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CHAPTER 1
Introduction to Money
and Banking
TEACHING
OBJECTIVES
Goals
of Chapter 1
A.
Provide an introduction to the textbook.
B.
Discuss two main themes in the book.
C.
Describe the value of money and banking for
everyday life.
D.
Discuss why government policy is so crucial
for money and banking.
E.
Examine ten surprising facts about money
and banking that will be discussed in greater detail in the book.
TEACHING
NOTES
A.
Introduction
1. Money
flows around the world and is affected by government policy
2. People
encounter money and the financial system frequently
3. If
economic policy is poor, the economy does not work well
4. The
Federal Reserve is a key policy institution; its decisions have worldwide
implications
B.
What Is in This Text?
1. The
Value of Money and Banking for Everyday Life
a)
The amount you must repay on a car loan is
affected by decisions of the Federal Reserve
b)
The interest rate on mortgage loans depends
on many factors, including the Federal Reserve’s decision
c)
The returns from investing in the stock
market depend on the profits of corporations, which in turn depend on economic
growth
d)
Understanding interest rates and returns to
the stock market will help you make better decisions
2. Why
Is Government Policy So Crucial for Money and Banking?
(1)
Economic policy affects everyone in her or
his everyday life
(2)
Policy matters more for the financial
system than for other industries because of externalities
a)
Who are the policymakers, and why are they
so important?
(1)
Policymakers are a diverse group, including
the Securities and Exchange Commission, accounting rule-makers, and the FDIC
(2)
They are important because their decisions
affect the nation in many ways
b)
What is the Federal Reserve?
(1)
The Federal Reserve determines the money
supply, sets rules for check clearing, distributes currency, and supervises and
regulates banks
(2)
A major decision by the Fed is to change
the target for the federal funds rate
C.
Ten (Surprising) Facts Concerning Money and
Banking
1. Most
financial formulas—no matter how complicated they look—are based on the
compounding of interest
a)
Complicated formulas related to financial
transactions are based on the simple idea of compounding
b)
Borrowing requires repayment plus interest
c)
Interest compounds over time; interest
today is earned on interest earned previously
d)
Compounding makes a large difference over
long periods
e)
Compounding is the major principle in
finance
2. More
U.S. currency is held in foreign countries than in the United States
a)
More U.S. dollars circulate outside the
United States than within
b)
Foreigners use U.S. dollars to avoid
problems caused by inflation in their own countries
c)
U.S. taxes are lower because foreigners use
U.S dollars, as the U.S. government profits from the sale of currency to foreigners
3. Interest
rates on long-term loans generally are higher than interest rates on short-term
loans
a)
There are many different interest rates
b)
The longer the time before a loan is
repaid, the higher the interest rate usually is
c)
The higher interest rate on long-term loans
arises from lender’s preferences and the increased riskiness of long-term loans
4. To
understand how interest rates affect economic decisions, you must account for
expected inflation
a)
People do not care about how many dollars
they earn from lending; they care about what they can buy
b)
How much a lender can buy in the future
depends on the expected inflation rate
c)
People form expectations of inflation in
different ways, depending on circumstances
d)
The real interest rate is of concern to
investors; policymakers can change the nominal interest rate, but changes in
the real interest rate depend on changes in people’s inflation expectations
5. Buying
stocks is the best way to increase your wealth—and the worst
a)
Deciding how to invest your savings depends
on your willingness to take risk
b)
Investing in the stock market may yield high
returns, but it is very risky
c)
Stock investors should understand both, how
the stock market works within the financial system, and what a particular
investment will yield
6. Banks
and other financial institutions made major errors that led to the financial
crisis of 2008
a)
Banks were relatively healthy in the 1990s
and the early 2000s
b)
Rapid growth in housing prices led banks
and mortgage brokers to make loans to people who did not have sufficient income
to pay back the loans
c)
When housing prices dropped, banks lost
money on subprime loans and mortgage-backed securities
d)
The global financial system froze up and a
deep recession followed
7. Recessions
are difficult to predict
a)
A recession occurs when overall business
activity declines
b)
Recessions are difficult to predict;
indicators that seem to predict recessions at one time lose their predictive
ability at other times
c)
But, analysis can reveal the economy’s
susceptibility to a shock that may lead to a recession
8. The
Fed creates money by changing a number in its computer system
a)
Money is created when the Federal Reserve
buys government securities, which it does by writing down a larger number in
its computer system
b)
Dollar bills come into being when the
Federal Reserve gives them to banks in exchange for reducing the number in the
computer system representing banks’ deposits
c)
If the Federal Reserve creates too much
money, the inflation rate rises, so the Federal Reserve limits money creation
9. In
the long run, the only economic variable the Federal Reserve can affect is the
rate of inflation—the Fed has no effect on economic activity
a)
The Fed can change economic activity, in
the short run, by changing the money supply and interest rates
b)
In the long run, the Fed’s policy does not
affect economic activity, but only determines the inflation rate
10. You
can predict how the Federal Reserve will change interest rates using a simple
equation
a)
We can use our knowledge about the Fed’s
actions, in the short run and long run, to predict its behavior
b)
The Fed’s decisions largely depend on the
level of output relative to potential and the inflation rate relative to its
desired level
c)
The Taylor rule is an equation that
describes the Fed’s behavior reasonably well
ADDITIONAL
ISSUES FOR CLASSROOM DISCUSSION
1.
Ask your students which of the ten facts
they found most surprising. For those of us who teach money and banking or
macroeconomics, none of the facts are surprising at all. But, students with
little backgrounds in economics are often quite surprised by many of the ten
facts. In giving speeches as a Federal Reserve economist, I found that fact
number 9, that the Fed can only affect inflation in the long run, comes as a
surprise to almost everyone.
2.
It may be interesting to talk about fact
number 5, “buying stocks is the best way to increase your wealth—and the worst”
now, and then come back to it when you get to Chapter 7. It seems that almost
everyone who has not looked at the data on stock returns thinks that if only
they had some wealth, they could make a fortune in the stock market. Giving
them a healthy dose of reality is a goal of the book and should be clear in
Chapter 7.
3.
The idea that recessions are difficult to
predict, which is idea number 7, is one that many people struggle with. A
useful class discussion can arise from the question: How can the government use
policies to prevent recessions if they are not predictable in the first place?
That is a tough one to answer!
ADDITIONAL
TEACHING NOTES
Policy
Issue: How Much Should Policymakers Do?
A key question that every policymaker faces
is: how much should I do? That decision influences everyone, because how
policymakers answer that question determines whom citizens vote for and how
they perceive government.
In this textbook, we will look at both
sides of the coin, divided between activist policy, in which the government
does a lot, and passive policy, in which the government does little. In some
cases, it will be clear that activist government policy is wrong. But in others
(such as setting up accounting rules), it is equally clear that government
policy actions are valuable.
In 2000, for example, the Securities and
Exchange Commission (SEC) passed a new rule about “fair disclosure.” It stopped
the practice that many companies had engaged in, of telling some people (usually
investment analysts from Wall Street) useful information about the company and
its future prospects. Why did the SEC adopt this rule? Because it gave the Wall
Street guys a big advantage over the average investor, who did not have access
to the same information. Prior to the rule, it would be common for an analyst
from a large Wall Street firm to call the president of a company with
questions, the president would disclose valuable information, and the analyst
would then often write a favorable report on the company. The average investor
might eventually learn the same information, but in the meantime the Wall
Street firm and its clients would have already benefited by purchasing the
company’s stock. This gave an unfair advantage to Wall Street firms and their
clients. The new rule levels the playing field for all investors.
We will spend a lot of time in this
textbook discussing monetary policy, and address the tremendous debate over how
activist policy should be. Keynesian theory in the 1970s suggested that
monetary policy could offset many disturbances in the economy. But the Great
Inflation of the 1970s caused economists to rethink the ability of policymakers
to fine-tune the economy. On the other hand, the deep recession of 2008-2009
led to resurgence of Keynesian policies. If policymakers are to be less
activist, how much should they do? Should they act based on their discretion,
keeping in mind the failures of the past? Chairman Bernanke testified that the
Fed should do its best with the models it has to help the economy. But, some
economists think the Fed should instead eliminate its discretion and follow a
simple rule, such as, “make the money supply grow 5 percent each year.”
Others, such as Mickey Levy of Bank of
America Securities, argue that, “The Fed must avoid being sidetracked from its
long-run objectives; in the past, attempts to over-manage the economy by
smoothing short-run fluctuations, calming financial market turmoil, stabilizing
currency fluctuations, or responding to fiscal policy have been destabilizing.”
Levy thinks that most of the Fed’s actions are counterproductive, doing more
harm than good. He would rather see the Fed focus on its long-run goals and
stop engaging in policy to affect the economy in the short run. Levy did admit,
however, that after the financial shock of the fall of 2008, “financial markets
have stabilized and the economy has adjusted, benefiting primarily from the
Federal Reserve’s extraordinary liquidity provisions.”
In research studies on monetary policy,
economists have found some support for that argument. In comparing the
performance of different rules for monetary policy, a number of studies have
shown that when the Fed tries to respond to short-run fluctuations in economic
growth, it tends to have worse overall performance than if it focuses solely on
inflation.
In the past, macroeconomic theory has
suggested that policymakers can do exactly what Levy cautions against. As a
discipline, macroeconomics was really begun by John Maynard Keynes, who was responding
to depressed economic conditions worldwide. Keynesian theory, as it was
subsequently developed, showed that there was a large range of government
policies that could be useful in getting an economy out of recession or
depression. Indeed, graduate schools in economics today teach students how
government policy works to manipulate the economy in the short run. Keynes
argued however, that “in the long run, we’re all dead,” and so did not worry
too much about the permanent consequences of the policies he advocated. That
argument was a cop out—we care about our children and our children’s children,
so we care about the long run.
So, what should monetary policymakers do?
Should they try to correct short-run problems, if doing so has adverse long-run
consequences? Is there a way to act in the short-run that will not be
detrimental in the long run? As we will see in Chapters 17 and 18, monetary
policy has a big impact on the short-term growth rate of the economy, but in
the long run it can only affect inflation. We will examine the constraints on
setting monetary policy, how the long run and the short run are related, and
offer some advice for making policy. As usual, there is some truth to both
sides of the argument about activism, but Levy’s cautionary words are worth
heeding.
Policy
Matters
To convince you that policy matters, let’s
look at some examples of recent events in which major problems were either
caused by or strongly affected by policy decisions. These include the Great
Depression, the Great Inflation of the 1970s, and Japan’s Depression in the
1990s.
The
Great Depression. From 1929 to 1939, the U.S. economy
performed poorly. The number of unemployed workers rose to very high levels,
with the unemployment rate (the number of unemployed workers divided by the
number of people willing and able to work) rising from about 4 percent in 1928
to about 9 percent in 1930, then rising to the range of 20 to 25 percent in the
early 1930s. An economic recovery began in 1933, but the unemployment rate declined
only gradually, and was still almost 20 percent in 1938. Preparations for World
War II finally began to drive down the unemployment rate, which fell below 5
percent in 1942 and was about 1 percent during the war, in 1944.
Economists do not agree on the exact cause
of the Great Depression, but many point to the contribution of several
government policies: monetary policy, trade policy, and industrial policy.
First, monetary policy helped drag the
economy down. The Federal Reserve System had come into being in 1915, but Fed
leaders did not really understand what monetary policy could and could not do. They
thought that monetary policy was helping the economy, but their conceptual
models were flawed, and they were actually contributing to the downturn by
causing the supply of money in the economy to decline. Federal Reserve
policymakers thought that the demand for money was declining, but they did not
realize that it did so because the amount of money they were supplying was
falling.
Second, the U.S. government pursued a trade
policy that was also a major contributing factor. With the passage of the
Smoot-Hawley Tariff Act in 1930, the United States imposed strong tariffs on
imported goods. Not surprisingly, other countries retaliated. The result was a
severe contraction in U.S. trade with foreign countries, which was another
force driving the U.S. economy into depression.
Third, in response to the depth of the
Great Depression, the United States modified its industrial policy to help
businesses, but the policy changes were counterproductive. Some economists
argue that the National Industrial Recovery Act may have prevented an economic
recovery from occurring because it allowed many industries to gain monopoly
power and gave workers large pay increases. The result was a reduction in
output and the demand for workers, thus choking off the economy’s recovery.
The Great Depression thus stands as the
greatest policy disaster in U.S. history. The Great Depression only ended when
the United States entered World War II and wartime production brought an
economic recovery. Though there was no clear cause of the depression, errors in
monetary policy, trade policy, and industrial policy definitely contributed to
it.
The
Great Inflation of the 1970s. In the United
States in the 1960s, Keynesian economic theory (which we will discuss in
Chapter 12) was used by government policymakers, who were able to successfully
fine-tune the economy—or so it appeared. In the early 1970s, President Richard
Nixon declared that “we’re all Keynesians now” and leading economists thought
that there might never again be an economic recession because policymakers
could control the economy with great precision. Suddenly, however, the economy
went into a tailspin at the same time that inflation was rising. The rise in
both unemployment and inflation was impossible, according to the dominant
Keynesian theory of the era. And there was worse to come throughout the 1970s.
Two major oil-price shocks caused major restructuring in the economy, leading
many firms to change the way they produced goods. Inflation jumped from about 2
percent in the first half of the 1960s to nearly 10 percent in the second half
of the 1970s and early 1980s. This was the largest sustained increase in the
inflation rate in U.S. history, thus deserving the name Great Inflation.
What happened? Was the failure one of
theory, or policy, or both? Most likely, it was a combination of both,
influenced heavily by our economy’s past history and proclamations by
economists that they had solved the business cycle. Because inflation is caused
by the Federal Reserve when it allows the money supply to grow too rapidly, the
blame rests clearly on the Fed. But why did the Fed allow inflation to become
so high, when inflation is the only major economic variable that the Fed can
influence in the long run? Why was the Fed so complacent? The Fed itself
believed the current state-of-the-art economic theory, which was the Keynesian
view that recessions could be offset by increasing the growth rate of money in
circulation. The Fed tried to combat the recessions of the late 1960s, mid 1970s,
and early 1980s with faster and faster money growth. But because people’s
expectations of inflation changed in response, the Fed’s policies were ineffective
at increasing economic growth and instead simply fueled inflation. So, the
blame might instead be placed on incorrect economic theory, rather than on the
Federal Reserve itself. Of course, had the Fed reduced the growth rate of
money, the Great Inflation would not have occurred, but the recessions in the
1960s, 1970s, and 1980s would likely have been deeper and longer, for which the
Fed would have taken the blame.
The Great Inflation finally ended in the
early 1980s, when the Federal Reserve, led by Chairman Paul Volcker, stepped on
the money brakes, reducing the growth rate of the money supply dramatically.
However, a period with two sharp recessions followed, and the economy took
quite some time to recover. The episode convinced many economists that inflation,
when allowed to become very high, was very costly to the economy. It also
convinced many monetary policymakers that they must never allow inflation to
rise significantly because the costs of reducing inflation are tremendous.
Japan’s
Depression in the 1990s. Japan’s experience in the
1990s represents yet another policy failure. It is also a shocking event, given
Japan’s history. In the 1980s, Japan’s economy appeared close to overtaking the
U.S. economy as the dominant force in the world. But there were deep-rooted
problems under the surface. Corporations were heavily involved in the banking
business, to the point where many investments were made without being
questioned by the financiers. The government was entangled in private industry
and did everything it could to prevent business firms from failing. Financial
markets were poorly developed, in part because the accounting rules were not as
clear as in the United States. These elements did not hold Japan back in the
1980s, as its pace of economic growth increased sharply. Japan, after all, did
many things right, especially in organizing production in the manufacturing
industry—techniques that were copied throughout the world. But, with cozy
lending practices, a poorly developed financial sector, and government
interference in the economy, the system was set for failure. In the late 1980s,
a speculative frenzy arose in Japan in which the price of land rose to
unbelievable levels. At one point, the plot of land on which the Imperial
Palace sits in Tokyo was worth more than all the land in Manhattan. The
Japanese stock market rose very sharply in the 1980s, but much of that was
based on the inflated value of real estate.
Japan went bust in the 1990s. The downturn
began when monetary policymakers tried to take some air out of the bubble in
real-estate prices by tightening monetary policy. People began to realize that
corporate profits were based on rising land values, not profitable production.
As the Japanese stock market fell, and land prices fell, investors learned that
the economy lacked a strong financial framework. Over the following decade, the
Japanese government tried to prop up the economy using traditional methods, but
never understood the fundamental problems in the economy. Japan’s economy
remained in a depression for over a decade, thanks in large part to a failure
of policy.
So, government policy is important. It can
influence the short-term direction of the economy for many years. Policy can
induce good or bad behavior on the part of people in the economy, with
far-reaching consequences. That is why we will spend a significant amount of
time on it throughout this textbook.
The
Importance of Economic Theory
Good economic policy requires good economic
theory. There is nothing worse than well-meaning, intelligent, but uninformed
people making policy decisions. Without a framework for understanding how
policy works and what its consequences are, a policymaker is adrift. Economic
theory is valuable because it gives the policymaker options within a rigorous
foundation. Economists may not have all the answers, but they know when the
answers are wrong, and that knowledge can prevent policy errors.
For example, as we will see in Chapter 18,
monetary policymakers often set policy by choosing a short-term real interest
rate. (You will recall that the real interest rate is the nominal interest rate
minus the expected inflation rate.) Economists think that the difference
between the level of this short-term real interest rate and its long-run equilibrium
level can be used as a measure of the impact of monetary policy on the economy
in the short run. The higher the real interest rate is relative to its long-run
equilibrium value, the tighter is monetary policy. But what is the level of
this real interest rate in long-run equilibrium? We might guess that the
long-run equilibrium real interest rate is the historical average of the real
interest rate, which is about 2 percent. While that is a reasonable first
guess, the problem is that, on average, monetary policy was historically too
easy and inflation was undesirably high. If we look at periods in which
inflation was relatively stable or had declined, we see that the real interest
rate averaged 3 to 4 percent in those periods. So, we might guess that the
equilibrium real interest rate is about 3 percent (because rates above 3
percent are associated with declining inflation).
But, the problem is not as simple as this.
So far, we have been assuming that the equilibrium real interest rate is
constant over time. However, we know that the economy has changed in
significant ways. In particular, economic growth was much more rapid in the
1950s and 1960s than it was in the 1970s, 1980s, and early 1990s. Economic
theory tells us that when economic growth is faster, the equilibrium real
interest rate is higher. So, policymakers, trying to think about the
equilibrium real interest rate, need to understand that the real interest rate
was higher in the 1950s and 1960s than it was in the 1970s, 1980s, and early
1990s. Because, the late 1990s brought economic growth back up to the levels it
achieved in the earlier period, the equilibrium real interest rate also likely
rose in that period. Thus, policymakers thinking about setting interest rates
benefit from economic theory in helping them determine the equilibrium level of
the real interest rate.
In addition to its value in helping
policymakers, economic theory is valuable of its own accord, because it helps
us understand how the world works. This textbook is written in a policy
context, and policy is important because it influences the economy, but the
economy on its own is even more worthy of study.
REFERENCES
The
Great Depression
Cole, Harold L., and Lee E. Ohanian. “The
Great Depression in the United States from a Neoclassical Perspective,” Federal
Reserve Bank of Minneapolis Quarterly
Review (Winter 1999), pp. 2–24.
Friedman, Milton, and Anna J. Schwartz. A Monetary History of the United States,
1867–1960
(Princeton, N.J.: Princeton University
Press, 1963).
Prescott, Edward C. “Some Observations on
the Great Depression,” Federal Reserve Bank of
Minneapolis Quarterly Review (Winter 1999), pp. 25–31.
The
Great Inflation of the 1970s
DeLong, J. Bradford. “America’s Peacetime
Inflation: The 1970s,” in Reducing
Inflation: Motivation and Strategy, edited by Christina D. Romer and David
H. Romer (Chicago: University of Chicago Press, 1997), pp. 247–80.
Lansing, Kevin J. “Exploring the Causes of
the Great Inflation,” Federal Reserve Bank of San
Francisco Economic Letter 2000-21, July 7, 2000.
Japan’s
Depression in the 1990s
Krugman, Paul. “Time on the Cross: Can
Fiscal Stimulus Save Japan?”
.
Roubini, Nouriel. “Japan’s Economic
Crisis,” November 12, 1996.
.
The
Economist. “Japan’s Economic Plight: Fallen Idol.”
June 20th, 1998, pp. 21-23.
How
Much Should Policymakers Do?
Greenspan, Alan. “Rules vs. Discretionary
Monetary Policy,” speech on September 5, 1997 at Stanford University, posted on
the Web at http://www.federalreserve.gov/boarddocs/speeches/1997/19970905.htm.
Levitt, Arthur. “The Importance of High
Quality Accounting Standards,” speech on September 29,
1997.
Levitt, Arthur. “Renewing the Covenant with
Investors,” speech on May 10, 2000.
Levy, Mickey. “Don’t Mix Monetary and
Fiscal Policies: Why Return to an Old, Flawed
Framework?” Bank of America Securities Economic and Financial Perspectives,
October 19, 2000.
Levy, Mickey. “Monetary and Fiscal Policies
Following Crisis Management.” Shadow Open Market Committee, September 30, 2009
.
Securities and Exchange Commission. “Final
Rule: Selective Disclosure and Insider Trading,” on the Web at http://www.sec.gov/rules/final/33-7881.htm.
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