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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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