In the long-run, when the government does nothing, the output in the economy will be
KEY POINTS:
I. Economic activity fluctuates from year to year.
II. Three Key Facts about Economic Fluctuations
III. Explaining Short-Run Economic Fluctuations
IV. The Aggregate-Demand Curve
V. The Aggregate-Supply Curve
(A new computer chip would not be sufficient to shift the LRAS) As a result, it has shifted the long-run aggregate-supply curve to the right. b. Opening up international trade has similar effects to inventing new production processes. Therefore, it also shifts the long-run aggregate-supply curve to the right. E. Why the Aggregate-Supply Curve Is Upward Sloping in the Short Run
VI. Two Causes of Recession
VII Monetary Policy VIII Fiscal Policy A. Government Purchases B. Reduction in Taxes More Monetary Policy Banks and the Money Supply A. The Simple Case of 100-Percent-Reserve Banking 1. Example: Suppose that currency is the only form of money and the total amount of currency is $100. a. Definition of reserves: deposits that banks have received but have not loaned out. 2. The financial position of the bank can be described with a T-account:
a. Before the bank was created, the money supply consisted of $100 worth of currency. b. Now, with the bank, the money supply consists of $100 worth of deposits. Definition of reserve ratio: the fraction of deposits that banks hold as reserves. c. Now First National decides to set its reserve ratio equal to 10% and lend the remainder of the deposits. The bank’s T-account would look like this:
When the bank makes these loans, the money supply changes. Now, after the loans, deposits are still equal to $100, but borrowers now also hold $90 worth of currency from the loans. 1. The creation of money does not stop at this point. 2. Borrowers usually borrow money to purchase something and then the money likely becomes redeposited at a bank. 3. Suppose a person borrowed the $90 to purchase something and the funds then get redeposited in Second National Bank. Here is this bank’s T-account (assuming that it also sets its reserve ratio to 10%):
4. If the $81 in loans becomes redeposited in another bank, this process will go on and on. 5. Each time the money is deposited and a bank loan is created, more money is created. The Fed’s Tools of Monetary Control 1. Definition of open market operations: the purchase and sale of U.S. government bonds by the Fed. a. If the Fed wants to increase the supply of money, it creates dollars and uses them to purchase government bonds from the public in the nation's bond markets. b. If the Fed wants to lower the supply of money, it sells government bonds from its portfolio to the public in the nation's bond markets. Money is then taken out of the hands of the public and the supply of money falls. c. If the sale or purchase of government bonds affects the amount of deposits in the banking system, the effect will be made larger by the money multiplier. d. Open market operations are easy for the Fed to conduct and are therefore the tool of monetary policy that the Fed uses most often. 2. Definition of reserve requirements: regulations on the minimum amount of reserves that banks must hold against deposits. a. This can affect the size of the money supply through changes in the money multiplier. b. The Fed rarely uses this tool because of the disruptions in the banking industry that would be caused by frequent alterations of reserve requirements. 3. Definition of discount rate: the interest rate on the loans that the Fed makes to banks. a. When a bank cannot meet its reserve requirements, it may borrow reserves from the Fed. b. A higher discount rate discourages banks from borrowing from the Fed and likely encourages banks to hold onto larger amounts of reserves. This in turn lowers the money supply. c. A lower discount rate encourages banks to lend their reserves (and borrow from the Fed). This will increase the money supply. d. The Fed also uses discount lending to help financial institutions that are in trouble. |