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Money Supply, Money Demand, and the Banking System

Money Supply Q uantity of money as the number of dollars held by the public, and we assumed that the Federal Reserve controls the supply of money by increasing or decreasing the number of dollars in circulation through openmarket operations. the money supply is determined not only by Fed policy but also by the behavior of households (which hold money) and banks (in which money is held). We begin by recalling that the money supply includes both currency in the hands of the public and deposits at banks that households can use on demand for transactions, such as checking account deposits. That is, letting M denote the money supply, C currency, and D demand deposits, we can write Money Supply = Currency + Demand Deposits 100-Percent-Reserve Banking We begin by imagining a world without banks. In such a world, all money takes the form of currency, and the quantity of money is simply the amount of currency that the public holds. For this discussion, suppose that there is $1,000 of...
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Investment

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Business Fixed Investment The largest piece of investment spending, accounting for about three-quarters of the total, is business fixed investment. The term “business” means that these investment goods are bought by firms for use in future production. The term “fixed” means that this spending is for capital that will stay put for a while, as opposed to inventory investment, which will be used or sold within a short time. Business fixed investment includes everything from office furniture to factories, computers to company cars. The standard model of business fixed investment is called the neoclassical model of investment. The neoclassical model examines the benefits and costs to firms of owning capital goods. The model shows how the level of investment—the addition to the stock of capital—is related to the marginal product of capital, the interest rate, and the tax rules affecting firms. The Rental Price of Capital To see what variables influence the equilibrium rental ...
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Goverment Debt vs Deficit

A Distinction with a Difference Despite starting with a common syllable and having deceptively similar meanings, the words don’t even have the same etymology. “Debt” derives from the Latin for “owe,” “deficit” from the word for “lacking,” or “fail”; literally, the opposite of “to do.” That alone should give you a hint as to the difference between them. Debt is money owed, deficit is net money taken in (if negative). That’s the short version, but it bears some exposition. Let’s tackle debt first, since it’s nominally larger. The U.S. federal debt is $18.3 trillion, the deficit $1 trillion, and it’ll never be the other way around. The former is a lifetime running tally, while the latter is an amount calculated over a particular period. If the federal debt increases by $100 billion tomorrow, that would give us a total of $18.4 trillion, where it’ll stay until the next increase or decrease (excluding interest). So it’s not as if everything resets to zero when the current period ends. W...
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Stabilization Policy

Should Policy Be Active or Passive? Policymakers in the federal government view economic stabilization as one of their primary responsibilities. Monetary and fiscal policy can exert a powerful impact on aggregate demand and, thereby, on inflation and unemployment. When the president is considering a major change in fiscal policy, or when Bank Indonesia is considering a major change in monetary policy, foremost in the discussion are how the change will influence inflation and unemployment and whether aggregate demand needs to be stimulated or restrained. Lags in the Implementation and Effects of Policies Economic stabilization would be easy if the effects of policy were immediate. But, economic policymakers face the problem of long lags. Indeed, the problem for policymakers is even more difficult, because the lengths of the lags are hard to predict. These long and variable lags greatly complicate the conduct of monetary and fiscal policy. Some policies, called automatic stabilizer...
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Aggregate Supply and the Short-run Tradeoff between Inflation and Unemployment

The Basic Theory of Aggregate Supply There are two prominent models of aggregate supply. In both models, some market imperfection causes the output of the economy to deviate from its natural level. As a result, the short-run aggregate supply curve is upward sloping rather than vertical, and shifts in the aggregate demand curve cause output to fluctuate. These temporary deviations of output from its natural level represent the booms and busts of business cycle -The Sticky-Price model The model emphasizes that firms do not instantly adjust the prices they charge in response to changes in demand. There are various ways to formalize the idea of sticky prices, the simplest one is first, consider the pricing decisions of individual firms and then add together the decisions of many firms to explain the behavior of the economy as a whole. -The Imperfect-Information Model Contrary from the precious model, this model prices are free to adjust to balance supply and demand. This models...
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Aggregate Demand

The Mundell-Fleming Model and the Exchange-Rate Regime. The Key Assumption: Small Open Economy With Perfect Capital Mobility. This world interest rate is assumed to be exogenously fixed because the economy is sufficiently small relative to the world economy that it can borrow or lend as much as it wants in world financial markets without affecting the world interest rate. The Goods Market and the IS * Curve The Mundell–Fleming model describes the market for goods and services much as the IS–LM model does, but it adds a new term for net exports. In particular, the goods market is represented with the following equation: Y = C(Y – T) + I(r) + G + NX(e). The Money Market and the LM * Curve The Mundell–Fleming model represents the money market with an equation that should be familiar from the IS–LM model: M/P = L(r,Y). Trade Policy: Suppose that the government reduces the demand for imported goods by imposing an import quota or a tariff. How a Fixed-Exchange-Rate System Works ...
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What is Economic Fluctuation?

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  Introduction to economic fluctuations Economic fluctuations present a recurring problem for economists and policymakers. On average, the real GDP of the United States grows between 3 and 3.5 percent per year. But this long-run average hides the fact that the economy’s output of goods and services does not grow smoothly. Growth is higher in some years than in others; sometimes the economy loses ground, and growth turns negative. These fluctuations in the economy’s output are closely associated with fluctuations in employment. When the economy experiences a period of falling output and rising unemployment, the economy is said to be in recession. GDP and Its Components The economy’s gross domestic product measures total income and total expenditure in the economy. Because GDP is the broadest gauge of overall economic conditions, it is the natural place to start in analyzing the business cycle. What determines whether a downturn in the economy is sufficiently severe to ...
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