Economics: Principles and Policy Essay Assignment Help

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

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.

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

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 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

not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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

not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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:

1. Bank profitability

• Interest on loans minus interest on deposits

2. Discretion over the money supply

• By lending, banks essentially create money
• Amount of money created depends on how much banks hold in reserve

3. 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

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 2 Changes in Bank-a-Mythica’s Balance Sheet, January 2, 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 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

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 6 Changes in Second National Bank’s Balance Sheet

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 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?

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 7 Changes in the Balance Sheet of Bank-a- Mythica

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 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

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 8 Changes in the Balance Sheet of First 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.

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

PLACE THE ORDER WITH US TODAY AND GET A PERFECT SCORE!!!