Economics: Principles and Policy Essay Assignment Help
William J. Baumol, Alan S. Blinder, John L. Solow
14th edition
Powerpoint Slides prepared by: Philip Heap, James Madison University
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © 2000 Cengage. All Rights
Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or
in part.
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Part 3
Fiscal and Monetary Policy
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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 12
Money and the Banking System
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
An Opening Quote
[Money] is a machine for doing quickly and commodiously what would be done, though less
quickly and commodiously, without it.
John Stuart Mill
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Circular Flow Diagram
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Why are Banks So Heavily Regulated?
- Regulation and deregulation of banks since the 1970s
- Banks regulated for two main reasons
- Allows better control of the money supply
- Concern for safety of depositors
- Run on a bank
- Many depositors withdraw cash from their accounts all at once
- Runs could lead to bank failure, which could spread
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Figure 1 Bank Failures in the United States, 1921–2017
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
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The Nature of Money 1 of 4
- Barter versus Monetary Exchange
- Barter
- System of exchange in which people trade one good for another
- Money is not used as an intermediate step
- Requires the double coincidence of wants
- Money
- Greases the wheels of exchange and makes the economy more productive
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
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The Nature of Money 2 of 4
- Money and its functions:
- Medium of exchange
- The object or objects used to buy and sell other items such as goods and services
- Unit of account
- Standard unit for quoting prices
- Store of value
- Store wealth from one point in time to another
- Why may money not be a good store of value?
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Nature of Money 3 of 4
- What serves as money?
- Cattle, stones, candy bars, cigarettes, woodpecker scalps, porpoise teeth, giraffe tails, cigarettes, large disk shaped boulders
- Commodity money
- An object in use as a medium of exchange that also has a substantial value in alternative nonmonetary uses
- To be useful as a medium of exchange, a commodity must be:
- Easily divisible
- Uniform or readily identifiable quality
- Storable and durable
- High value per unit of volume and weight
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Nature of Money 4 of 4
- Commodity money
- Gold and silver
- Fiat money
- Money that is decreed as such by the government
- Little value as a commodity
- Maintains its value as a medium of exchange because
- People have faith that the issuer will stand behind the pieces of printed paper and limit their production
- Evolution of money
- Commodity money → Full-bodied paper money → Partially backed money → Fiat Money
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
How the Quantity of Money is Measured 1 of 2
- Two measures of the money supply:
- M 1: Narrowly defined money supply
- Coins and paper money in circulation
- Traveler’s checks
- Conventional checking accounts and other checkable deposit balances
- M 2: Broadly defined money supply
- M 1
- Money market deposit accounts
- Money market mutual funds
- Savings accounts
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Figure 2 Two Definitions of the Money Supply, Aug 2018
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
How the Quantity of Money is Measured 2 of 2
- Other measures of the money supply:
- M 3 and beyond
- Near moneys
- Liquid assets that are close substitutes for money
- Liquidity – the ease with which it can be converted into cash
- Should we include credit cards in the money supply?
- We will assume that money consists of coins, paper money, and checkable deposits (most of M 1)
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Banking System 1 of 6
- How banking began
- Gold used as commodity money
- Gold stored at goldsmiths who issued paper receipts backed by gold
- Clever goldsmiths started lending out “gold”
- Fractional reserve banking system
- A system under which bankers keep only a fraction of deposits as reserves
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Banking System 2 of 6
- Three features of a fractional reserve banking system:
- Bank profitability
- Interest on loans minus interest on deposits
- Discretion over the money supply
- By lending, banks essentially create money
- Amount of money created depends on how much banks hold in reserve
- Exposure to runs
- Keep prudent reserves and lend out money carefully
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Banking System 3 of 6
- Principles of bank management: Profit vs. Safety
- How do banks maintain a reputation for prudence?
- Maintain a sufficient level of reserves to minimize vulnerability to runs
- Be cautious in making loans and investments since large losses undermine confidence
- Failure during the housing boom of 2003-2006
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Banking System 4 of 6
- What government regulations are in place to ensure the safety of the banking system?
- Bank regulations
- Rules designed to ensure depositors’ safety and to control the money supply
- Deposit insurance
- Guarantees that depositors will not lose money even if their bank goes bankrupt
- Federal Deposit Insurance Corporation (F D I C 1933)
- Why might deposit insurance lead to a system that is less safe?
▶ Moral hazard problem
⁃ If insured against consequences of risk people engage in riskier behavior
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Banking System 5 of 6
- Another government regulation in place to ensure the safety of the banking system:
- Bank supervision
- Periodic bank examinations
- Tighter regulation since 2006
- Bureau of consumer financial protection
- Mechanism for dealing with potential failure of giant banks
- Limit the kinds and quantities of assets in which banks may invest
▶ Banks can own only limited amounts of common stock
▶ Limits on proprietary trading
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Banking System
- One more regulation:
- Reserve requirements
- Minimum amount of reserves required by law
- Proportional to the volume of deposits
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Systemic Risk and the “Too Big to Fail” Doctrine 1 of 2
- Systemic risk
- Risks to the entire system of banks or financial institutions
- Arises because these institutions (large) are linked in many ways
- banks runs spread
- exchanging funds with other banks and non-bank financial institutions
- Systemically important (or “too big to fail”)
- A financial institution that by virtue of its size or interconnectedness, can threaten the entire system if it runs into trouble
- Lehman Brothers and American International Group (A I G)
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Systemic Risk and the “Too Big to Fail” Doctrine 2 of 2
- The Dodd-Frank Act, 2010
- The Fed given powers to supervise systemically important financial institutions
- Tougher regulatory regime than ordinary banks
- New procedure in case of failure
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Origins of the Money Supply
- A Banker’s Books
- Asset
- An item of value that an individual or firm owns
- Liability
- An item of value that an individual or firm owes
- Many liabilities are known as debts
- Balance sheet – accounting statement
- Left side: values of all assets
- Right side: values of all liabilities and net worth
- Net worth = Asset – Liabilities
- Assets = Liabilities + Net Worth
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Table 1a Balance Sheet of Bank-a-Mythica, Dec 31, 2018
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Banks and Deposit Creation 1 of 12
- Suppose someone deposits $100,000 into their checking account. How does that lead to a multiple expansion of the money supply?
- Deposit creation:
- The process by which a fractional reserve banking system turns $1 of bank reserves into several dollars of bank deposits
- Assume the required reserve ratio is 20%. How much excess reserves does the bank have?
- Excess reserves are reserves held in excess of the legal minimum
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Table 1b Balance Sheet of Bank-a-Mythica, Dec 31, 2018
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Banks and Deposit Creation 2 of 12
- We will use a T Account to trace the $100,000 checking deposit
- Shows changes in balance sheets rather than the balance sheets themselves
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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Table 2 Changes in Bank-a-Mythica’s Balance Sheet, January 2, 2019
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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Table 3 Changes in Bank-a-Mythica’s Balance Sheet, January 3–6, 2019
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Table 4 Changes in Bank-a-Mythica’s Balance Sheet, January 2–6, 2019
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Banks and Deposit Creation 3 of 12
- What we have so far:
- $100,000 less in cash
- $100,000 more in checkable deposits
- $80,000 loan so new cash in circulation
- So money supply up by $80,000
- What happens when that $80,000 is deposited into a different bank: First National Bank?
- First National bank has excess reserves
- It lends out those reserves, which get deposited at Second National Bank
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Table 5 Changes in First National Bank’s Balance Sheet
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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Table 6 Changes in Second National Bank’s Balance Sheet
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Banks and Deposit Creation 4 of 12
- We could go on to the Third National Bank, Fourth, Fifth . . .
- When does it end?
- Assumptions
- Each bank holds exactly 20% required reserves
- Each loan recipient redeposits entire proceeds into the next bank
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Figure 3 The Chain of Multiple Deposit Creation
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Banks and Deposit Creation 5 of 12
- Suppose someone deposits $100,000 into their checking account. How does that lead to a multiple expansion of the money supply?
- Putting it all together:
- Initial deposit of $100,000 in cash
- Led to $500,000 in new deposits
- Money supply rises by $400,000
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Banks and Deposit Creation 6 of 12
- The math behind expansion of the money supply:
- Each column forms a geometric progression
- In the last figure, each entry is 80% of the previous entry or 20% less
- From before we learned:
▶ 1 + R + R2 + . . . = 1 / (1 – R)
- Applying this to the $100,000 initial deposit:
▶ $100,000 + $80,000 + $64,000 + $51,200 +. . .
▶ = $100,000 x (1 + 0.80 + 0.802 + 0.803 + . . .)
▶ = $100,000 x 1/(1 – 0.80)
▶ = $500,000 in new deposits
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Banks and Deposit Creation 7 of 12
- In general
- If the required reserve ratio = m
- Deposit multiplier = 1/m
- Banking system can convert each $1 of reserves into $1/m in new deposits
- Oversimplified Deposit Multiplier
- Ratio of newly created bank deposits to new reserves
- Change in deposits = (1/m) ˣ change in reserves
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Banks and Deposit Creation 8 of 12
- Oversimplified Deposit Multiplier
- Ratio of newly created bank deposits to new reserves
- Change in deposits = (1/m) ˣ change in reserves
- Our example:
- m = 20%
- Change in reserves: $100,000
- Change in deposits = (1/0.20) x $100,000
- = $500,000
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Banks and Deposit Creation 9 of 12
- What has happened to to the money supply?
- Cash: – $100,000
- Deposits created: + $500,000
- Money supply: + $400,000
- What happens if someone withdraws $100,000 from Bank A Mythica?
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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Table 7 Changes in the Balance Sheet of Bank-a- Mythica
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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Banks and Deposit Creation 10 of 12
- At Bank Mythica:
- Loses $100,000 in checkable deposits
- Required reserves fall by $20,000
- Actual reserves fall by $100,000
- Excess reserves short by -$80,000
- Outstanding loans paid off and no new loans until bank has accumulated enough reserves
- Where did the borrowers get the money to pay off the loans?
- They made withdrawals from other banks: First National
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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Table 8 Changes in the Balance Sheet of First National Bank
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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Banks and Deposit Creation 11 of 12
- At First National Bank:
- Loses $80,000 in checkable deposits
- Required reserves fall by $16,000
- Actual reserves fall by $80,000
- Excess reserves short by -$64,000
- Outstanding loans paid off until bank has accumulated enough reserves
- And the process continues:
- Change in deposits = -$100,000 – $80,000 – $64,000 – . . .
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Banks and Deposit Creation 12 of 12
- What is the overall effect?
- Deposits: -$500,000
- = (1/ 0.20) x – $100,000
- Loans: -$400,000
- Reserves: -$100,000
- Money supply: -$400,000
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Why the Deposit-Creation Formula Is Oversimplified
- Our money multiplier only accurate under two circumstances
- Every recipient of cash must redeposit cash to another bank rather than hold it
- Every bank must hold reserves no larger than the legal minimum
- What happens if individuals and business firms hold more cash?
- Fewer dollars of cash available for use as reserves
- Limits the multiple expansion of bank deposits
- Smaller money supply
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Figure 3 Chain of Multiple Deposit Creation
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Why the Deposit-Creation Formula Is Oversimplified 1 of 3
- What happens if individuals and business firms hold more cash?
- Fewer dollars of cash available for use as reserves
- Limits the multiple expansion of bank deposits
- Smaller increase in the money supply
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Why the Deposit-Creation Formula Is Oversimplified 2 of 3
- What happens if banks decide to hold on to some excess reserves?
- Limited multiple expansion of bank deposits
- Smaller supply of money
- Excess reserves after September 2008
- Failure of Lehman Brother led to financial panic
- Banks held excess reserves at a massive scale
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Figure 4 Excess Reserves in the U.S. Banking System, 2008–2018
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Why the Deposit-Creation Formula Is Oversimplified 3 of 3
- Excess reserves after September 2008
- From $2 billion to $267 billion by October 2008, $800 billion by January 2009.
- Currently at $1.9 trillion
- 10 fold increase in excess reserves, but M1 less than tripled
- Banks holding on to excess reserves reduces the multiplier effect
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Need for Monetary Policy 1 of 2
- Government regulates money supply to maintain stability
- During a recession
- Banks prone to reduce money supply
- Increase excess reserves
- Decrease lending to less creditworthy applicants
- Without government intervention contraction in money supply would aggravate recession
- Federal Reserves during the Great Depression
- and the recent financial crisis and Great Recession
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Need for Monetary Policy 2 of 2
- During an economic boom
- Banks expand money supply
- Undesirable momentum to economy
- Without government intervention rapid money growth could lead to inflation