ECON 110 The Money Market - Answers St. Charles Community College Econ 110 Principles of Macroeconomics Answers to Class Discussion Problem

ECON 110 The Money Market - Answers

St. Charles Community College
Econ 110 Principles of Macroeconomics
Answers to Class Discussion Problem

Illustrate the following situations using supply and demand curves for money:
a.    The Fed temporarily reduces the discount rate during a national crisis.

Answer:  By temporarily reducing the discount rate, the Fed makes it easier for banks to borrow money to cover their reserves.  This will increase the money supply and move the money supply curve to the right.  Since we don’t know anything about the “national crisis” we can’t say how the money demand curve demand might move.

Note:  This is one of the actions taken by the Fed on 9/11/01 when the airplanes flew into the World Trade Center.  The Bank of New York had its operations center in the World Trade Center, and the Fed came to its rescue. 

b.    The Fed acts to hold interest rates constant during a period of inflation.

Answer:  During periods of inflation, when prices are rising and goods and services cost more, consumers and firms generally elect to hold higher money balances to cover the higher costs of transactions  This means that the demand for money increases, and the money demand curve shifts to the right.  If the Fed elects to hold interest rates constant as the problem states, the Fed will take action to increase the money supply as required.  This means that the money supply curve will shift to the right until the interest rate is at its original level.

c.    The Fed decreases the reserve ratio during a period of negative GDP growth.

Answer:   In general terms, when the economy is not as healthy as it had been previously, consumers and firms become more cost conscious and tend to rein in their spending due to uncertainty.  This means that the demand for money balances will decrease, and the money demand curve will shift to the left.

If the Fed elects to decrease the reserve ratio, commercial banks are free to lend a higher percentage of their loanable reserves which will expand the money supply.  The money supply curve then shifts to the right.

d.    The Fed buys bonds in the open market during a period of slow economic growth.

Answer:  This is the most common technique used by the Fed to spur the economy during periods of slow economic growth.  When the Fed buys bonds, it puts more money into circulations through the banking system and the money multiplier.  The money supply curve will shift to the right.


The money demand curve movement can get complicated.  If firms and consumers perceive the slow economic growth as an increase in economic growth, just at a slower rate, the demand for money will increase and the money demand curve will shift to the right as shown below.

However, if firms and consumers perceive the slow economic growth as a mild recession, they may become pessimistic and reduce their demand for money balances.  In that case the money demand curve could shift to the left.

e.    The Fed sells bonds in the open market during a period of rapidly increasing government spending.

Answer:  When the Fed sells bonds, money is taken out of circulation and the money supply decreases.  Periods of rapidly increasing government spending means that the economy will grow, possibly introducing some amount of inflation.  With prices increasing, households and firms will need to hold cash balances for transactions and the demand for money will increase.   The money demand curve will shift to the right.

f.    The Fed sells bonds in the open market during a recession.

Answer:  Again, firms and consumers tend to be hesitant in their spending during uncertain times.  Money demand tends to fall, causing the money demand curve to shift tot the left.  When the Fed sells bonds money is taken out of circulation, and the money supply curve shifts to the left.  This action by the Fed can compound the recessionary problem in the economy, and that’s exactly what happened in this country and in Europe during the great depression of the 1930’s.

The affect on interest rates in this case is uncertain.  It is entirely possible that the two activities could cancel each other in such a manner that interest rates will be affected.

g.    The Fed buys bonds in the open market during a period of high consumer optimism.

Answer: When the Fed buys bonds, money is put into circulation.  The money supply increases, and the money supply curve shifts to the right.  When consumers are optimistic, they spend.  At such times those consumers need more money for transactions, and the money demand curve shifts to the right also.

h.    A large number of consumers begin using debit cards and ATM machines.

Answer:  When technology is introduced into the banking system to the convenience of consumers, the demand for money decreases.  The money demand curve shifts to the left. Think of it this way. You can go to the mall with no cash.  If you see goods or services that you wish to purchase you can go to the nearest ATM machine or reach for your debit card in your wallet or purse. The problem does not say that there is any action on the part of the Fed, so we’ll assume that the Fed takes no action.

i.    The Fed sells securities in the open market during a period of high inflation.

Answer:  This situation could very similar to question “e” except that we now have inflation for certain.  During periods of inflation, firms and consumers increase their demand for money because prices are higher.  The money demand curve shifts to the right.  When the Fed sells bonds, it takes money out of circulation, and the money supply curve shifts to the left.

j.    Commercial banks raise their loan requirements during a downturn in the economy.

Answer:  Commercial banks commonly protect themselves during bad times by scrutinizing the loan applicants very carefully.  They want to protect themselves against bad loans.  They raise their loan requirements for households and for firms.  Fewer loans mean less money in circulation which means that the money supply curve shifts to the left.  On the demand side, firms and consumers tend to be more conservative in their spending during recessions, so the money demand curve shifts to the left also.

Balance of Trade (BOT):

BOT and BOP

Balance of Trade (BOT):

Balance of trade is the net exports (NX) of a country.

Net exports are the difference between a country's merchandise exports (X) minus its imports (M).

BOT includes import and export of physical and tangible goods.

Three situations are possible:
1)

NX = X-M = 200 - 100 (billion dollars) = 100 billion dollars.

This is called a trade surplus.

So if X > M, we have a trade surplus.

2)

NX = X-M = 200 - 400 (billion dollars) = -200 billion dollars.

This is called a trade deficit.

So if X < M, we have a trade deficit.

3)

NX = X-M = 200 - 200 (billion dollars) = zero dollars.

This is called a trade balance.

So if X = M, we have balanced trade.

Factors affecting BOT:

1) Exchange rates:

2) Trade barriers:

3) Economic conditions at home:

Economic impact of balance of trade:

Y= C + I + G + (X-M) or

National income = Consumption + Investment + Government expenditure + (Exports - Imports)

All of these variables have a positive impact on Y (GDP), except imports, which affects national income negatively.

But in GDP accounting, exports and imports are not accounted for independently, but their net effect called net exports (X-M) affects the GDP.

If X > M, (X-M) is positive, it's a trade surplus and it positively affects GDP.

If X < M, (X-M) is negative, it's a trade deficit and it negatively affects GDP.

If X = M, (X-M) is zero, it is balanced trade, and there is no effect on the GDP.

Balance of payments (BOP):

It is a record of all transactions between one country and the rest of the world.

It includes goods, services, financial assets, real assets, transfer payments etc.

It is measured per year.

It is a flow variable.

It is recorded on a double entry bookkeeping methodology.

The outflow of payments made to the rest of the world is recorded in the debit account.

The inflow of receipts from the rest of the world is recorded in the credit account.

The debit side has to match the credit side and hence it is called the Balance of payments (BOP).

The major entities in the BOP are:
1) Balance of trade:

This is the trade in physical goods.

Exports are credited in the BOP account since it is an inflow of money.

Imports are debited in the BOP since it is an outflow of money.

If exports >imports = trade surplus

If exports< imports = trade deficit

If exports = imports then we have balanced trade.

The USA has had a trade surplus up to 1975.

Ever since then, a trade deficit.

2) Balance on goods and services:

The balance of trade is balanced on goods (physical entities).

Then there is trade in services which are intangible as insurance, banking, tourism, consulting etc.

If the USA gets paid for any of these then it enters as a credit in the BOP.

If the USA pays for any of these then it enters as a debit in the BOP.

 

BOT Surplus or deficit good or bad

BOT: Surplus or deficit: good or bad:

This is the balance of trade (BOT) or also called net exports.

BOT is the difference between a country's exports (X) and imports (M)

If X is greater than M: Net exports are positive and it's a BOT surplus

If X=M: Net exports are zero and it's called balanced trade

If X is less than M: Net exports are negative and it's a BOT deficit

Another term used in this context is "trade balance."

It is the difference between a country's output and her consumption or domestic demand (DD.)

If output > DD, the gap is exported and it's a trade surplus since X is greater than M

If output =DD, X=M and we have balanced trade

If output < DD, the gap is imported and it's a trade deficit since X is less than M

BOT is influenced by factors affecting a country's exports and imports.

Broadly they are:
1)

Value of the local currency, in our example US dollars.

If the dollar is strong, M is greater than X and we will have a trade deficit.

If the dollar is weak, M is less than X, we will have a trade surplus
2)

Cost of production at home and abroad.

If the cost of production at home is greater than the cost of producing the same good abroad, imports will exceed exports.

This is generally true for the USA vis-a-vis China.

Reversely, if the cost of production at home is less than the cost of producing the same good abroad, exports will exceed imports.

This is generally true for China vis-a-vis USA.

3)

The stage of the business cycle a country is in.

For example generally during the expansionary phase of the business cycle, income is high and so consumption is also possibly high, leading to greater imports and reduced exports.

But, the reverse causality is also possible.

During the expansionary phase the local currency (the US dollar) may become stronger and appreciate, reducing exports and increasing imports.

The final net outcome between the two is difficult to predict.

The reverse causation logic can be applied in case of a country in the downswing of a business cycle.

 

BOP Surplus or deficit Good or bad

If a country's export (X) is less than its imports (M), there is a trade deficit.

That deficit is counterbalanced by earnings from foreign investments and / or foreign loans.

Thus overall a country's BOP is always in balance.

But individual items can be in surplus or deficit, as discussed below.

BOP constitutes the current account (CUA) and the capital account (CAA).

The current account is the sum of the country's:

a) Balance of trade (X-M)

b) Factor earnings which is the difference between a country’s earnings from foreign investment and her payments to foreign investors.

c) Cash transfer amongst countries which includes present (current) transactions only, not future income and payment streams

CAA is the net change in foreign assets.

It is the loans and investments done in foreign countries and the payments from foreign countries.

Like the CUA, it includes present (current) transactions only, not future income and payment streams

BOP= CUA-CAA (+ or -) balancing item.

The balancing items are statistical / accounting errors which are allowed because of the complexity of the items and the volume of revenues in the CUA and the CAA.

By standard double entry accounting methods, CUA-CAA =0, but it is not always exact.

So some accounting leeway is allowed in terms of the balancing item.

In the CUA we have exports (accounted in credit) and imports (accounted in debit) double entry accounting system.

Net outcome:

M>X: trade deficit

M=X: balanced trade

M<:X trade surplus

Factor earnings go in credit, while factor payments go in debit entry.

Reserve account includes the country’s central bank (The Federal Reserve in the USA) reserves of foreign exchange.

The International Monetary Fund (IMF) definition of BOP:

BOP=CUA-CAA-FA(= + or -) BI

Financial accounts are transactions in capital accounts.

Causes of BOP imbalances:

The USA has a large deficit which could be because of:

a) It could be caused by factors affecting the current account

b) High exchange rate or appreciating dollar, resulting in high imports from the rest of the world, and low exports to the rest of the world.

c) Government running large deficits

d) Safe haven currency.

This is true for the USA, where other countries save / invest in US dollar assets and so money flows into the USA.

This lowers interest rates and raises consumption.

This increases the deficit.

The US dollar is the reserve currency for the world.

Even today, 65% of global reserves are in US dollars, and 25% in EURO.

A BOP crisis is a bad thing and should be avoided.

It happens when a country has taken huge loans for consumption which is not self sustaining, meaning they do not give returns.

Once the investor countries become concerned about the loanee country being able to pay back its loans, they may start to call back their loans.

This is the genesis of a BOP crisis.

Once a crisis of confidence atmosphere is created, the country’s foreign exchange value drops, exacerbating the crisis.

Cure:

Changing the country’s exchange rate which is very difficult (nay impossible) under the floating exchange rate system.

The logic is say if the dollar depreciates (on its own) then US exports will increase while her imports will decrease, improving her BOT account.

But the flip side of this is that a depreciating dollar may cause concern in financial markets, resulting in outflow of funds, causing the capital account to deteriorate.

So it is a balancing act.

Business Cycles

Business Cycles

Business cycles are the normal fluctuations of the output of a country.

A country's GDP (under normal circumstances) grows over time, but not at a steady rate.

These fluctuations of the GDP around its steady trend growth line are called business cycles

The upswings and down swings of an economy are called business cycles.

Sometimes the pace of economic growth is rapid, called the expansionary phase, and sometimes the economy slows down called the contractionary phase.

From the diagram below we can see the phases of a business cycle

The steady growth line or trend line is the straight line in the middle.

The economy (or any economy) does not grow in that steady fashion.

Rather it grows in spurts, gathers momentum and grows even faster.

Then the reverse happens, and the economy slows down, and now it gathers momentum in the reverse direction, and slows faster and faster.

This is the real way an economy grows over time, not in a steady manner.

So the irregular ups and downs of an economy are called business cycles.

The phases of a business cycle are:
1) Expansionary Phase:

In the business cycle diagram it is the phase when the economy is moving up the cycle of growth, from a trough towards a peak.

During this phase there is growth observed all around the economy.

Every economic sector is growing.

Producers are producing more because people are buying /demanding more goods and services.

To produce more goods and services you need more people, so employment goes up.

These newly employed spend their money on food, clothing housing etc.

Thus the income in those sectors go up too.

As aggregate demand goes up, so do prices and profits.

So more investment is done in the economy.

Thus a positive momentum or a positive domino effect builds up and the economy grows faster and faster.

Income, employment, output all increase.

2) Contractionary Phase:

The reverse of an expansionary phase happens here.

In the business cycle diagram it is the phase when the economy is moving downfrom a peak towards a trough.

During this phase there is contraction in economic activity observed all around the economy.

Every economic sector is reducing its output.

Producers are producing less because people are buying /demanding fewer goods and services.

To produce fewer goods and services you need fewer people, so employment goes down.

These newly unemployed spend less money on food, clothing housing etc.

Thus the income in those sectors go down too.

As aggregate demand goes down, so do prices and profits.

So private investment goes down too.

Thus a negative downward momentum or a negative domino effect builds up and the economy shrinks or contracts faster and faster.

Income, employment, output all tend to decrease.

3) Peak:

This is the highest point an economy can reach.

It is the end of the expansionary phase.

Everything that happens in the expansionary phase, culminates at this point.

Beyond this point, the downturn starts.

4) Trough:

This is the lowest point an economy can reach.

It is the end of the contractionary phase.

Everything that happens in the contractionary phase, culminates at this point.

Beyond this point, the upturn starts.

Length of a business cycle:

A business cycle is measured as the time period between two troughs or two peaks.

Related Concepts:
Recession:

The technical definition is: It is decrease in real GDP over two consecutive quarters.

But if there is a significant contraction in economic activity all around, we generally call it a recession.

A trough in general would indicate a recession.

Depression:

A severe form of recession is a depression.

Transaction Costs

key terms

Smaller transaction costs in doing business across borders

• A transaction cost is any cost associated with the exchange of a good from one hand to another. Examples include transportation costs, fees, and time.   
• A common currency eliminates the transaction costs associated with exchanging currencies in order to buy and sell goods across countries. Smaller transaction costs make it easier and more profitable to buy and sell across countries; increasing trade between the two countries.

Example 1:
Let’s say you want to buy a pair of pants. Before the monetary union, you would look and see that pants cost either 100 mark in Germany or 8505 pesetas in Spain. You look up the exchange rate to convert the currency, and find that the exchange rate between the mark and the peseta is 100 mark = 8507 pesetas. With 100 mark you could have bought a pair of pants in Germany, but if you had exchanged those 100 mark for pesetas you could buy the Spanish pants and still have 2 pesetas remaining, so the pants are slightly cheaper in Spain. Assume that you only have mark and no pesetas. You might want to buy the cheaper Spanish pants, but in order to buy them you have to go to your local currency converter, which costs you time and inconvenience (which is worth something to you).  Once you get to the currency exchanger, he/she might actually charge you a small fee for his/her work in exchanging your currency.  At this point is it not worth buying the Spanish pants because of the cost involved in getting the pesetas.
Now assume you have a common currency and pants are 100 € in Germany and 99 € in Spain. You no longer have to exchange any currency because you, Spain, and Germany are using euros. You can just as easily buy the cheaper Spanish pants.
Example 2:
You can also think about it in terms of the seller. If the seller wants to take pants made in Spain and sell them in Germany, he/she must accept mark in Germany then exchange them into pesetas to conduct the business of pant making in Spain. There will be a transaction cost of exchanging his/her earned mark into pesetas. This makes selling in Germany just a little more expensive. If however, there are no currency transaction costs, the cost of selling in Germany becomes less expensive and more Spanish companies will sell in Germany, increasing trade (especially if their product is just a little cheaper – leading to greater competition and better prices for consumers). 

Automatic Stabilizers

key terms

Automatic changes to taxes and government spending due to fluctuations in the economy.
Example – economic downturn:

• Assume that a negative aggregate demand shock causes income to fall and unemployment to rise.

• Tax revenue falls because
• Unemployed persons pay fewer taxes.
• Those who experience a cut in pay (or have to work fewer hours) pay fewer taxes and might drop into a lower tax bracket

• Government spending increases as it pays more in
• Unemployment insurance.
• Welfare (such as food stamps or healthcare to the uninsured).
• Job training of the recently unemployed.

• Thus the economic downturn causes taxes to fall and spending to increase.  This has the same effect on the deficit, output, and unemployment as discretionary fiscal policy without any legislated changes to the tax rate or spending.

Example – economic upswing:

• Assume Spain has a positive aggregate demand shock causing incomes to rise and unemployment to fall.

• Tax revenue increases because
• There are more people earning taxable income.
• Those who get a raise or work more hours have greater income and thus a greater tax liability. They may even creep into a higher tax bracket.

• Government spending decreases as it pays less in welfare including
• Unemployment insurance.
• Food stamps or healthcare to the uninsured.
• Job training of the recently unemployed.

Thus the economic upswing causes taxes to rise and spending to fall.  This has the same effect on budgetary balances, output, and unemployment as discretionary fiscal policy without any legislated changes to the tax rate or spending.

Appreciation and Depreciation

key terms

: An increase in the exchange rate.

• • The home currency becomes relatively more expensive for foreigners to buy. Appreciation also means that foreign currency becomes relatively cheaper for you to buy.
  • If prices in both countries remain the same, an appreciation will make foreign goods relatively cheaper to you, leading to an increase in imports. It also means that, even if prices remain the same, your goods will be more expensive to foreigners. They will buy less of your goods and exports will fall. As a result, your country's net exports will fall.
  • This change to net exports causes a leftward shift of the aggregate demand curve.
  • Example
  • Example: The exchange rate for the dollar with the euro on June 12, 2008 was e = 0.645 €/$. If the exchange rate today were e = 0.9 €/$ the dollar has appreciated.
  • Let's say I was interested in importing Belgian chocolates that cost 1 € each.
  • If I took $100 to the exchanger on June 12th I would have gotten 65 € and could have bought 65 chocolates.
  • If I took $100 to the exchanger today I would have gotten 90 € and could have bought 90 chocolates!
• depreciation: A decrease in the exchange rate.
  
  • The home currency becomes relatively cheaper for foreigners to buy. Depreciation also means that foreign currency becomes relatively more expensive for you to buy.
    • If prices in both countries remain the same, depreciation will make foreign goods relatively more expensive to you, leading to a fall in imports. It also means that, even if prices remain the same, your goods will be cheaper to foreigners. They will buy more of your goods and exports will rise. As a result, your country's net exports will increase.
    • This change to net exports causes a rightward shift of the aggregate demand curve curve.
• Example:  The exchange rate for the dollar with the Euro on June 12, 2008 was e = 0.645 €/$.  If the exchange rate today were e = 0.5 €/$ the dollar has depreciated.

• Let’s say I was interested in importing Belgian chocolates that cost 1 € each
• If I took $100 to the exchanger on June 12th I would have gotten 65 € and could have bought 65 chocolates.
• If I took $100 to the exchanger today I would have gotten 50 € and could have bought 50 chocolates!
• The price of Belgian chocolates did not change, but because the dollar depreciated they become more expensive to you – so you import less.

« Back to the top

Gross Domestic Product

key terms

Mouse-over a link for a quick definition or click to read more in-depth!

GDP is the amount of all goods and services produced in a given country within a given period of time.
GDP measures a country’s total output. Since (almost) all that is produced in an economy is eventually bought and turned into income, GDP also measures the amount of income earned in a country for a given period of time.

• How is GDP used?
  • GDP measures how big a nation is in economic terms. 
  • GDP per capita is often used to compare the welfare of different countries. Because GDP is also a measure of income, GDP per capita gives an idea of how wealthy the people are on average for a given country. (note: per capita means that you divide total GDP by the number of people in the country)
  • The speed at which GDP grows determines how fast an economy is growing and how healthy the economy is. Higher growth most often means that the economy is strong. If the growth rate of GDP for a country were negative, that country is producing less this year than it did the previous year and the country is in what is called a recession.
  • The growth rate is calculated as the percentage change in GDP from one time period to the next

The following graph demonstrates the growth rate of GDP for the U.S. and the EU since 1993:

• How is GDP measured?
  • The most common way to measure GDP is called the expenditure approach. This approach measures GDP by looking at the amount of new goods and services purchased in a country for a given year. A simple equation is used: Y = C + I + G + NX
  • Let’s take Belgium in 2007 as an example. We find that GDP (Y) for Belgium in 2007 is equal to the total amount of goods and services bought by those living in Belgium in 2007 (consumption = C), plus the total amount of investment items bought by Belgium’s businesses and homeowners in 2007 (I), plus the amount of new goods and services bought by the government of Belgium in 2007 (G). The final piece takes into account the fact that people, businesses, and governments outside of Belgium buy Belgium goods (exports), and that people, businesses, and the government in Belgium buy goods produced in other countries (imports). The difference between these two is captured in net exports (NX). 
    • Note: Because GDP trying to provide a measure of what is produced in a country for a given year, only the purchase of new goods (no used cars here) are included in the expenditure approach.
  • GDP calculated this way is measured in terms of a country’s currency. For example, the GDP of Belgium in 2007 was 302 billion €. GDP measured in terms of a currency is called nominal GDP.
    • If nominal GDP increased from one year to the next you would not know if is rose because Belgium produced more or if it rose because the price level in Belgium rose. Measures of real GDP remove the influence that changing prices have on GDP in order to determine whether or not a country is producing more or less from year to year.

• What determines a country’s level of real GDP and its growth rate?
  • In the long run, GDP is determined by the long-run aggregate supply curve, and the growth of GDP is determined by population and technology growth. The rate at which a country should produce according to the long-run aggregate supply curve is called potential GDP.
  • In the short run, GDP is determined by the aggregate demand curve and the short-run aggregate supply curve. As these curves shift, you get temporary periods of high and low growth in GDP.