Counter Cyclical Policies

Structure of the Federal Reserve System

The US Central Bank

The System was created in 1913

Board of Governors runs the system with an appointed Chairman

          The chairman is appointed by the President, approved by the Senate

          This is currently Janet Yellen

          Famous prior Chairmen:  Paul Volcker, Alan Greenspan, Ben Bernanke

12 Fed Banks control Fed actions and currency distribution in their regions:

          A = Boston

          B = New York City

          C = Philadelphia

          D = Cleveland

          E = Richmond

          F = Atlanta

          G = Chicago

          H = St. Louis

          I  = Minneapolis

          J  = Kansas City

          K = Dallas

          L = San Francisco

         

The Federal Open Market Committee (FOMC) or (OMC) is in charge

          of the buying and selling of Fed Bonds…

          BB = BB (The Fed Buys Bonds to create Big Bucks = More Money Supply)    

          SB = SB (The Fed Sells Bonds to create Small Bucks = Less Money Supply)

The Federal Deposit Insurance Corporation (FDIC) has members of most banks in   

          the US and helps manage operations of member banks.  It also insures

          deposits of the private sector that are place in the banks

The Fed has many “tools” to help run the US banking and money supply systems.

          The main tools are the:

The buying and selling of Bonds
          The Fed Fund Rate Target

          The Discount Rate

          The Reserve Requirement

Interest Rate Basics

Fed Funds Rate

          FDIC member banks loan each other overnight funds in order

          to balance deposit accounts each day.  The interest rate they

          use to loan each other this money is the Fed Fund Rate.

          The Federal Reserve "targets" this rate by suggesting its

          raising or lowering and uses bonds to accomplish the targets.

          The Federal Reserve measures the rate in "basis points".

          100 basis points = 1%.

Discount Rate

          FDIC member banks, and other eligible institutions, may borrow

          short term loans directly from the Federal Reserve.  This is

          the "discount window", and is set above the Fed Fund Rate.

          Banks do not like to use the window, since it appears to be

          a move of "last resort" to have to turn to the federal government

          for loan funds.  The FOMC sets the Discount Rate.

Prime Rate

          This is the interest rate banks charge their most "credit

          worthy" borrowers.  Historically, the prime rate, in the US,

          has been set about 3% above the Fed Fund Rate.

                  

Private Rates

          These loan rates are set by supply and demand, the abilities

          of companies to loan out private monies, and subsidized

          federal monies.  Examples would include car companies

          "selling" "zero interest" loans, special student rate loans, etc.

          When companies use these tactics, they hope to regain

          profit with time limits to the special rates, less bargaining on

          the overall product price, heavy late payment fees, etc.

          Any rate below the Fed Fund Rate probably has some kind

          of financial trick attached to the contract.

Countercyclical Fiscal Policies

Domestic US Market:

Always conducted by Congress

Fighting a Recession:	Fighting Inflation:
Policy Name = Expansionary	Policy Name = Contractionary
Taxes = Cut	Taxes = Raise
Gov. Spending = Increase	Gov. Spending = Decrease
Budget Result = Deficit	Budget Result = Surplus
Aggregate Model:	Aggregate Model:
C should = increase	C should = decrease
G should = increase	G should = decrease
AD should = increase	AD should = decrease
Money Market:	Money Market:
DM will= increase	DM will= decrease
i should = increase	i should= decrease
(Ig on Aggregate Model will)= decrease	(Ig on Aggregate Model will)= increase
Loanable Funds…Market:	Loanable Funds…Market:
The budget issue will cause: deficit	The budget issue will cause: surplus
S LF = decrease	S LF = increase
DLF = increase	DLF = decrease

Connections: Countercyclical Monetary Policies

Domestic US Market

Always conducted by Federal Reserve (Central Bank)

Fighting a Recession:	Fighting Inflation:
Name = Easy Money or Expansion.	Name = Tight Money or Contract.
Bonds = Buy (Big Bucks)	Bonds = Sell (Small Bucks)
FFR Target = lower	FFR Target = raise
DR = lower	DR = raise
RR = lower	RR = increase
Money Market/Loanable Funds:	Money Market/Loanable Funds:
MS should = increase	MS should = decrease
Bank Loans = increase	Bank Loans = decrease
i, r should = decrease	i, r should = increase
Aggregate Model:	Aggregate Model:
Ig should = increase	Ig should = decrease
AD should = increase	AD should = decrease

Crowding Out

What is it?	A critique and flaw of Keynesian  policies that are applied to fight a recession. (An expansionary policy!)
Why does it happen?	The policy of cutting Taxes and raising Spending will create a budget deficit.
So?	The budget deficit must be funded and to do this Congress orders the sale of US bonds. (This is NOT a Monetary Policy tool used by the Fed)
Where does this money comes from?	Mostly from US citizens and companies and investment firms. (Some from foreign countries)
Therefore?	Money that could be spent on Consumption or used for Private Savings is now being used to buy   bonds.
On the Money Market?	This will cause the Money Demand curve to shift outward.  Remember this is a Fiscal event!
On the Loanable Funds Market?	This will cause the Supply  curve to shift inward  because we are not Saving money privately any more.
Also, on the Loanable Funds ?	This can cause the Demand  curve to shift outward    because the private and public demand for $ increases_.
On both graphs?	The nominal and real interest rate will increase.
Therefore, on the Investment D graph	The increase in nominal and real interest   rates will cause Ig to decrease.
Isn’t this counterproductive?	Yes.
Why do it?	Fiscal Policy supporters (Keynesians) insist that gains in C  and G  will outweigh any loss in future Ig.
Why?	C and G are greater than Ig and they are Short Run improvements.  Ig is longer run and Keynesians don’t worry about that.  In the long run we are all dead.
Anymore?	Yes, this is summarized on the Aggregate Model.  The AD will move outward due to the increases in C and G and then “maybe” move inward due to a loss of Ig, but not as much as the increase.  Therefore the economy improves.

Crowding Out

What is it?	A critique and flaw of Keynesian  policies that are applied to fight a recession. (An expansionary policy!)
Why does it happen?	The policy of cutting Taxes and raising Spending will create a budget deficit.
So?	The budget deficit must be funded and to do this Congress orders the sale of US bonds. (This is NOT a Monetary Policy tool used by the Fed)
Where does this money comes from?	Mostly from US citizens and companies and investment firms. (Some from foreign countries)
Therefore?	Money that could be spent on Consumption or used for Private Savings is now being used to buy   bonds.
On the Money Market?	This will cause the Money Demand curve to shift outward.  Remember this is a Fiscal event!
On the Loanable Funds Market?	This will cause the Supply  curve to shift inward  because we are not Saving money privately any more.
Also, on the Loanable Funds ?	This can cause the Demand  curve to shift outward    because the private and public demand for $ increases_.
On both graphs?	The nominal and real interest rate will increase.
Therefore, on the Investment D graph	The increase in nominal and real interest   rates will cause Ig to decrease.
Isn’t this counterproductive?	Yes.
Why do it?	Fiscal Policy supporters (Keynesians) insist that gains in C  and G  will outweigh any loss in future Ig.
Why?	C and G are greater than Ig and they are Short Run improvements.  Ig is longer run and Keynesians don’t worry about that.  In the long run we are all dead.
Anymore?	Yes, this is summarized on the Aggregate Model.  The AD will move outward due to the increases in C and G and then “maybe” move inward due to a loss of Ig, but not as much as the increase.  Therefore the economy improves.

As Japan Falls Into Recession, Europe Looks to Avoid It

As Japan Falls Into Recession, Europe Looks to Avoid It

By LIZ ALDERMAN and JONATHAN SOBLE

NOVEMBER 17, 2014

PARIS — Japan looked like the model for economic revival. Growth was back on track. The stock market was surging. Inflation, which had eluded Japan for decades, was even returning.

But Japan’s grand economic experiment, a combination of fiscal discipline and monetary stimulus, is collapsing. On Monday, the country unexpectedly fell into recession, a downturn that has painful implications for the rest of the world.

Japan’s unorthodox strategy was supposed to offer a road map for other troubled economies, notably Europe. Fiscal belt-tightening and tax increases, while leaning on the central bank to pump money into the economy, was expected to help overcome a malaise.

The formula, though, has failed to ignite a meaningful recovery in Japan — and has even added to its woes. Europe must now decide whether to follow Japan’s lead by injecting more money into the economy, as the region’s central bank considers a similarly aggressive bond-buying campaign known as quantitative easing. And the United States, which just ended its own six-year stimulus effort, doesn’t offer much of a cushion should other economies stumble further.

“The United States is about the only growth beacon in the global economy right now, and that is not a very nice place to be,” said Jacob Funk Kirkegaard, an economist at the Peterson Institute for International Economics in Washington. “An American growth pickup is positive, but it looks like the rest of the world is again going to be relying on the U.S. as a consumer of last resort.”

Japan’s prime minister, Shinzo Abe, won power two years ago on a promise to pull the economy out of nearly two decades of corrosive wage and price declines. The initial response of both Japanese consumers and global investors was ebullient: The economy surged during the first few months of his administration in early 2013, and Japanese stock prices soared.

Mr. Abe’s program, called Abenomics, at first relied on a one-two punch of government spending and financial support from the Bank of Japan, the country’s central bank. The bank sharply increased its program of buying government bonds and other assets, similar to the stimulus effort recently ended by the United States Federal Reserve.

In some ways, Japan has been more aggressive than the United States. Its bond-buying program, which was expanded last month, is now bigger relative to the size of its economy than the Fed’s was at its peak.

Much of the enthusiasm for Abenomics has evaporated, however. Some economists blame a lack of action by Mr. Abe’s government in areas beyond pump-priming stimulus, such as deregulation and trade.

A turn toward tighter fiscal policy has taken the majority of the blame. Government data released on Monday showed that the country unexpectedly fell into recession in the third quarter, hampered by rising sales taxes that have discouraged consumers from spending. Mr. Abe is expected to shelve a second tax increase, lest the Japanese economy and consumer confidence erode further.

“What Japan shows is that if you have longstanding economic stagnation, having an aggressive monetary policy and even sizable fiscal reform is not going to work without deep-rooted structural reform,” Mr. Kirkegaard said. “The experience of Japan must be at the top of the minds of European leaders.”

High on the agenda is whether Europe should pursue large-scale purchases of government bonds, so-called quantitative easing.

The European Central Bank recently said it was prepared to take additional steps to revive the struggling economy, by lending more to banks and buying bonds backed by mortgages and other assets. Critics say the bank has not acted nearly aggressively enough to help revive growth, which has essentially stagnated.

The similarities between the two places is strong, which has prompted some economists to wonder whether Europe will turn into another Japan.

Europe and Japan have stuck with various versions of austerity, neither pushing ahead with deep-seated changes to their economy that analysts say are needed to revive long-term growth. Europe is also increasingly facing down the Japan-like specter of deflation as a recovery lags.

The political debate is also developing along the same lines.

A number of countries, led by France and Italy, recently balked at European Union requirements to doggedly adhere to fiscal targets and eschew stimulus spending that some economists say is critical. Some economists say that Japan’s situation only adds to the argument that fiscal belt-tightening, while sometimes needed to mend a country’s finances, hurts growth when an economy is in decline.

European politicians now widely blame austerity policies for delaying a return to growth, but Chancellor Angela Merkel of Germany is wary of loosening requirements for fiscal discipline after runaway debt levels and high deficits helped generate the eurozone debt crisis. The region’s leaders are scheduled to meet in early December to discuss further strategies for growth.

“The main implication is we are beginning to see what it might look like in Europe if we go down that road,” said Bart van Ark, chief economist for the Conference Board, referring to Japan’s recession.

“Europe has the potential to become a second Japan in terms of significantly slowing demographics, and weak per capita income growth,” he said. The Japanese experience shows that efforts to keep the economy afloat with more inflation and growth don’t help sustain higher growth in the long term. What’s needed, he said, is a “reform agenda, and that is a very difficult strategy” for politicians to pursue in any country.

The problems in Europe and Japan put additional pressure on the United States and China, which face their own headwinds.

The United States increased at a healthy 3.5 percent annualized pace in the third quarter, and unemployment has fallen below 6 percent. But troubling signs remain, including less-than-robust consumer spending and a lift from military spending that may be temporary.

China, too, is under pressure. Growth in China has cooled to 7.3 percent. While that is the envy of many countries, a slow clip by Chinese standards has raised questions about the nation’s economic health.

The disparate issues — a weak recovery in Europe, slowing growth in China and other emerging markets, as well as Japan’s failure to sustain any sort of a turnaround — have rung alarm bells in Washington.

Last week, Treasury Secretary Jack Lew said in a speech in Seattle that the United States was increasingly being relied upon to perform as locomotive for a global recovery.

“But the global economy cannot prosper broadly relying on the United States to be the importer of first and last resort, nor can it rely on the United States to grow fast enough to make up for weak growth in major world economies,” he said.

After reading the article, what events led to Japan's recession?  How does the recession affect the U.S. economy and what actions can Congress and the Federal Reserve enact so that we can avoid what Japan is going through?

Wednesday Exam Study Guide

Creation of Money Problem

Assume that the reserve requirement is 20 percent and banks hold no excess reserves.

a).  Assume that Kim Deposits 100 cash from her pocket into her checking account.  Calculate each of the following.

          i) The maximum dollar amount the commercial bank can initially

                   lend

          ii) The maximum total change in demand deposits in the banking

                   system

          (iii) The maximum change in the money supply

b).  Assume that the Federal Reserve buys $5 million in government bonds

on the open market.  As a result of the open market purchase, calculate the maximum increase in the money supply in the banking system. 

c) Given the increase in the money supply in part (b), what happens to real wages in the short run?  Explain.

The best way to answer was to create and fill in the following:

a)

Assets	Liabilities
RR	DD
ER	(New)

b)

Assets	Liabilities
RR	DD
ER	(New)

Banks Creating Money Notes

Banks and the Creation of Money

Bank Balance Sheets

Key Concept Notes for an AP Macro Class

How do banks “create” money?

By lending out deposits that are used multiple times, just like the Consumption Multiplier Effect (1/1-MPC or 1/MPS)

Where do the loans come from?

From depositors who take cash and place it in accounts at banks

How are the amounts of potential loans calculated?

By understanding and applying the bank balance sheet system, also known as a “T-Account” that consists of “assets” and “liabilities” for banks

Bank Liabilities (the right side of the T Account Sheet):

#1 = Demand Deposits (also known as “Checkable Deposits”)(DD)         These are cash deposits from the public.         These are a liability because they belong to the depositors and can be           withdrawn by the depositors.

#2 = Owners Equity (also known as “Stock  Shares”)         These are the values of stocks held by the public ownership of bank           shares.

Key concept for AP concerning Liabilities:   If the demand deposit comes in from someone’s “cash” holdings, then   that demand deposit is already part of the Money Supply (M-1).  The cash   is simply being placed into a bank account.   If the demand deposit comes in from the purchase of bonds (by the Fed)   then this creates new cash and therefore creates new Money Supply (M-1).

Bank Assets (the left side of the T Account Sheet):

#1= Required Reserves (RR)        These are the percentages of demand deposits that must be held in the        vault so that some depositors have access to their money.  Textbooks        show that actual demand deposits can be as low as 3%, but they vary        based on the bank and the amount of the demand deposit.        AP will use 5%, 10%, or 20% for reserves….

#2 = Excess Reserves (ER)        These are the source of new loans.  These amounts will be applied to the        Monetary Multiplier/Reserve Multiplier        NOTE:  DD = RR plus ER

#3 = Bank Property Holdings (Buildings and Fixtures)        These are usually stated as a money value of the bank’s property…

#4 = Securities (Federal Bonds)         These are the bonds previously purchased by the bank, or new bonds         sold to the bank by the Federal Reserve.  These bonds can be         purchased from the bank, turned into cash that immediately becomes         available as “excess reserves”.

#5 = Customer Loans         This can be amounts held by banks from previous transactions, owed to          the bank by prior customers.

Money Creation (Using Excess Reserves)

Banks want to create profit.  They can generate profit by lending the excess reserves and collecting interest payments.  Since each loan will go out into customer’s and business’ accounts, more loans are created in decreasing amounts.  Each successive bank must pull some of the money out for required reserves.  A rough estimate of the number of loan amounts created by any first loan is the “monetary multiplier”.

The Monetary Multiplier (also known as):

Checkable Deposits Multiplier

Reserve Multiplier

Loan Multiplier

The formula is simple:  1divided by the reserve requirement (ratio)   An example = RR = 10% = 1/.1 = Monetary Multiplier of 10.

Excess Reserves are multiplied by the Multiplier to create new loans for the entire banking system and this creates new Money Supply.

Summary of Items to Know

Bank Balance Sheet =

Assets and Liabilities in a T Account

Liabilities =

Demand Deposits

Owner’s Equity (Stock Shares)

Assets =

Required Reserves

Excess Reserves

Bank Property (Buildings and Fixtures)

Securities (Bonds)

Loans

Assets must Equal Liabilities

DD = RR + ER

Money is Created through the Monetary Multiplier

ER x 1/RR (Multiplier)= New Loans throughout the banking system

The Money Supply is affected

Cash from a citizen becomes a DD, but does NOT change the Money Supply The ER from this cash becomes an “immediate” loan amount.

ER x Multiplier become New Loans and DO change the Money Supply

The Fed Buying bonds creates new loans and changes the Money Supply

IF the Fed buys the bonds on the open market, this also becomes a new   Demand Deposit amount. (2009 FRQ) IF the Fed buys bonds from accounts already held by a particular bank,   then the amount only becomes new Excess Reserves (2011 FRQ)

Supplemental Note about Bonds

Bond “prices” move opposite to the changes in interest rates. (2011 FRQ) Higher interest rates will push bond prices downward. (Less Money Supply) Lower interest rates will push bond prices upward. (More Money Supply)