Economics - The Macroeconomy (PDF)

Economics – AL Amali Paththamperuma UNIT 9 – The Macroeconomy – Prt 4 1. The Circular Flow of Income 2. Economic Growth and Sustainability 3. Employment and Unemployment 4. Money and Banking...

Economics – AL Amali Paththamperuma UNIT 9 – The Macroeconomy – Prt 4 1. The Circular Flow of Income 2. Economic Growth and Sustainability 3. Employment and Unemployment 4. Money and Banking 1  Economics – AL Amali Paththamperuma 4. Money and Banking Introduction to Money - Money is an item which people use to buy and sell goods and services. - Bank notes and coins (cash) are used mainly for small purchases. - Money in bank deposits is the main form of money. - It is transferred from one person to another person by direct debit, credit cards and smartphones. - In recent years, there has been the development of what is known as cryptocurrencies (also called digital money and electronic money). o These cryptocurrencies allow people to make and receive payments online, person to person, without the need for a commercial bank and not regulated by central banks. o The best known and most widely used cryptocurrency is bitcoin. o People can get bitcoins by accepting them in payment, buying them on special websites or carrying out tasks for the bitcoin system (known as mining). o Some people use cryptocurrencies to make payments hoping that they will rise in value. o However, their value is determined by demand and supply and their value has fluctuated considerably. o The extent to which they can be considered to be money is debatable as they have not yet become generally acceptable. The Functions of Money - The best-known function of money is to buy and sell goods and services, but it also carries out three other functions. - Each of these functions has a technical name. - Medium of exchange. o We sell goods and services for money. o We use the money we receive to buy other goods and services. 2  Economics – AL Amali Paththamperuma - Store of value. o Money enables people to save for future use. - Unit of account. o This function is also known as a measure of value. o Money enables the value of different items to be compared as prices are expressed in money terms. - Standard of deferred payment. o Money enables people, firms and the government to borrow and lend and to buy and sell in the future. The Characteristics of Money 1. Generally acceptable. o This is the most important characteristic. 2. Recognisable. o People have to identify the item as money. o Central banks make the country’s notes and coins distinctive. 3. Portable. o It must be easy to carry money around. 4. Divisible. o Any form of money must be divisible into units of different value. 5. Homogeneous. o Each unit of money must be identical. 6. Limited in supply. o If there is an unlimited supply of money, it would have no value. 7. Not easy to counterfeit. o If it was easy to counterfeit money, it would lose its value. o Central banks now build in special features to their bank notes to try to prevent counterfeiting 3  Economics – AL Amali Paththamperuma The Money Supply - The money supply is the total amount of money in an economy. - The money supply = currency in circulation + relevant deposits. - Governments measure the money supply o To gain information about trends in aggregate demand o The state of financial markets o To determine the direction of monetary policy. - Measuring the money supply is not straightforward as it is difficult to decide what to include in any measure of the money supply. - Economists define items as money if they fulfil the functions of money. - Since the extent to which they carry out these functions varies and can change over time, governments use a variety of measures of the money supply - There are two main measures of the money supply: o Narrow money:  This is money that is used as a medium of exchange  = notes in circulation + cash held in banks + balances held by commercial banks at the central bank.  Sometimes referred to as the monetary base. o Broad money:  This consists of the items in narrow money plus a range of items that are concerned with money’s functions as a store of value.  An example is money in savings accounts 4  Economics – AL Amali Paththamperuma The Quantity Theory of Money - Aggregate demand is influenced by the money supply and, in turn, can influence the money supply. - One theory which seeks to explain how changes in the money supply can have an impact on the economy is the quantity theory of money. - This theory is based on the Fisher equation: MV = PT (also commonly written as MV = PY) o where: M - money supply V - velocity of circulation (the number of times money changes hands) P - price level T / Y - transactions or output of the economy. - Both sides of the equation have to equal each other since both sides represent total expenditure in the economy. - To turn the equation into a theory, monetarists assume that V and T are constant, not being affected by changes in the money supply, so that a change in the money supply causes an equal percentage change in the price level. - However, Keynesians argue that the equation cannot be turned into a theory since V and T can change with a change in the money supply and so no predictions can be made about what effect a change in M will have on P. Keynesian and Monetarist Theoretical Approaches - Keynesians consider avoidance of unemployment as a key priority and favour government intervention to influence the level of economic activity as o They believe that if left to market forces, there is no guarantee that the economy will achieve a full employment level of GDP. o Indeed, they think that the level of GDP can deviate from the full employment level by a large amount and for long periods. o They argue that if there is high unemployment, the government should use a budget deficit to increase aggregate demand. 5  Economics – AL Amali Paththamperuma o They believe that a government can assess the appropriate amount of extra spending to inject into the economy in such a situation. - Monetarists consider the control of inflation as the top priority for a government. o They believe that the main role of a government is to control the money supply as they argue that inflation is the result of an excessive growth of the money supply. Functions of Commercial Banks - Commercial banks, also called high street banks and retail banks, carry out a range of functions. - They provide o Deposit accounts for their customers;  Demand deposit account (also known as a current account or sight account).  This type of account provides easy and quick access to the money in the account.  It is used mainly to receive and make payments. Customers can pay in and take out cash from this type of account.  Savings deposit account.  This type of account is used mainly as a way of saving. - Commercial banks hold a range of other assets such as cash, government securities and equities. - Commercial banks make most of their profits from lending. - Customers are usually given the opportunity to overdraw their deposit account by a certain value. - They can also ask for an overdraft which allows customers to spend more money than in their deposit accounts and charged an interest - Banks offer loans, usually for a particular purpose and a set amount of time and interest is charged - The interest rate for a loan is normally lower the rate on an overdraft. 6  Economics – AL Amali Paththamperuma The Objectives of a Commercial Bank - Commercial banks have three main objectives: o Profitability  Achieve high profits mainly by lending. o Liquidity  Banks need to have enough liquid assets, such as cash and short-term securities to meet the expected request by their customers to withdraw their money in cash  Liquid assets are the assets that will soon be turned into cash  However, liquid assets are not very profitable as no money is earned on holding cash. o Security  Commercial banks aim for security as they do not want to go out of business and they have to convince their customers that they are financially sound.  To achieve this aim they try to ensure they have sufficient financial capital to cover their risker loans.  A commercial bank will keep some assets that are liquid but not very profitable and some that are profitable but not very liquid and some of its profits Causes of Changes in the Money Supply - There are five main causes of an increase in the money supply in an open economy: 1. Increase in commercial bank lending 2. Increase in government spending financed by borrowing from commercial banks 3. Increase in government spending financed by borrowing from the central bank 4. Quantitative easing - the sale of government bonds to private sector financial institutions 5. more money entering than leaving the country. 7  Economics – AL Amali Paththamperuma Commercial Banks and Credit Creation - When commercial banks lend, they create money. - This is because when a bank gives a loan (also called an advance by bankers), the borrower’s account is credited with the amount borrowed. - From experience, banks have found that only a small proportion of deposits are cashed. - When people make payments, they tend to make use of credit cards, debit cards and online transfers where payment involve a transfer of money using entries in the records that banks keep of their customers’ deposits rather than by paying out cash. - Therefore, banks can create more deposits than they have liquid assets. - Nevertheless, they have to be careful when calculating what liquidity ratios (the proportion of liquid assets to total liabilities) to keep. - This ratio can be set by a central bank when it is called a reserve ratio. - The lower the proportion of liquid assets commercial banks keep, the more they can lend. - However, if they miscalculate and keep too low a ratio, or if people suddenly start to cash more of their deposits, there is a risk of a run on the banking system. - Banking is based on confidence and customers have to believe there is enough cash and liquid assets to pay out all their deposits even though, in practice, this is not going to be the case The Bank Credit Multiplier - By estimating what reserve ratio to keep, a bank will be able to calculate its bank credit multiplier. - When calculating its bank credit multiplier, a commercial bank will take into account its reserve ratio: - It is also possible to calculate the bank credit multiplier, in advance: 8  Economics – AL Amali Paththamperuma Reserve Ratio - If a bank keeps a reserve ratio of 5%, the bank credit multiplier will be 100 / 5 = 20. - With this knowledge, a bank can then calculate how much it can lend. - The bank first works out the possible increase in its total liabilities. - This is found by multiplying the change in liquid assets by the bank credit multiplier. - So, if the bank credit multiplier is 20 and liquid assets rise by $40 million, total deposits can rise by $40 million × 20 = $800 million. - To work out the change in loans (advances), the change in liquid assets is deducted from the change in liabilities. - This is because the change in liabilities will include deposits given to those putting in the liquid assets. - In the example, the change in loans can be $800 million − $40 million = $760 million. - However, in practice a bank may not lend as much as the bank credit multiplier implies it can. - This is because there may be a lack of households and firms wanting to borrow or a lack of credit- worthy borrowers. - If banks persist in lending to borrowers with poor credit ratings, as was the case in the US sub-prime market in 2008, the risk of default is high and can have serious consequences on a bank’s liquidity. - A bank is likely to change its reserve ratio if people alter the proportion of their deposits they require in cash, if other banks alter their lending policies or if the country’s central bank requires banks to keep a set reserve ratio. - A central bank may seek to influence commercial banks’ ability to lend. - For example, the bank may engage in open market operations. - These involve the central bank buying or selling government securities to change bank lending. - If the central bank wants to reduce bank loans, it will sell government securities. - The purchasers will pay by drawing on their deposits in commercial banks and so cause the commercial banks’ liquid assets to fall. 9  Economics – AL Amali Paththamperuma The Capital Ratio - The capital ratio is a commercial bank’s available financial capital expressed as a percentage of its riskier assets. - The available financial capital includes its retained profits and newly issued shares. - For example, if a commercial bank had a capital ratio of 8%, this would mean that 8% of its risker assets are covered by readily available financial capital. - The higher the capital ratio a commercial bank has, the more unexpected losses it can experience without going out of business. - The capital ratio is designed to protect the bank’s customers in the event of a financial crisis and to promote the stability of the banking sector by discouraging excessive risk taking The Role of a Central Bank - The central bank of a country carries out a range of functions. o Issues bank notes and authorises the minting of coins. o Bank of the commercial banks.  Commercial banks keep deposits in the central bank.  Central bank lends to commercial banks if they get into financial difficulty. (lender of last resort) o Banker to the government o Implement the government’s monetary policy Government Deficit Financing - If the government spends more than it raises in taxation, it will have to borrow and that is organised by the central bank. - If the central bank borrows, on behalf of the government, by selling government securities, to the non-bank private sector (non-bank firms and the general public), it will be using existing money as the purchasers will be likely to draw money out of their bank deposits. - Therefore, the rise in liquid assets resulting from increased government spending = fall in liquid assets as money is withdrawn. 10  Economics – AL Amali Paththamperuma - However, if a budget deficit is financed by borrowing from commercial banks or the central bank itself, the money supply will increase. Quantitative Easing - Quantitative easing is a situation where a central bank buys government and private securities, to increase the money sully and stimulate the economy - Commercial banks can lend more now with more liquid assets and that increase the money supply and reduce the short-term and long-term interest rate. - Therefore, increase investment and consumer expenditure and so aggregate demand and economic activity. Changes in the Balance of Payments - The total currency flow refers to the total net outflow or inflow of money resulting from international transactions, as recorded in the different sections of the balance of payments. - If export revenue > import expenditure, money will flow into the country on the trade balance. o Exporters will deposit the money into the country’s commercial banks, which will lead to a multiple increase in the money supply The Effectiveness of Policies to Reduce Inflation - Contractionary monetary and/or contractionary fiscal policy can be used to reduce inflation. - Supply-side policy can also be used in the case of cost-push inflation. - How effective policies are in reducing inflation depends on a number of factors. o Correct identification of the type of inflation  When the economy is operating at less than full employment. If a government then introduces contractionary monetary and fiscal policies, the fall in aggregate demand may not have much impact on the price level but could increase unemployment.  In practice, it is often difficult to distinguish between cost-push and demand-pull inflation. 11  Economics – AL Amali Paththamperuma  This is because once inflation is under way, it is usually a mixture of cost-push and demand-pull inflation.  Some policy tools can help to reduce both types of inflation, at least in the long run. - Governments and central banks make estimates of future inflation rates - It might be predicted that demand-pull inflation is accelerating and will cause a problem. - There is no guarantee that such a forecast is right and even if it is, it will take time to decide on the appropriate policy tool, implement it and for households and firms to react. - There may be limits on the policy tools a government can use. o Cant set its own interest rate if it is a member of an economic and monetary union o Reluctant to raise its income tax rate as it will encourage some of its skilled workers to emigrate and will discourage multinational companies from setting up in the country. o Though a government want to spend more on infrastructure to reduce cost-push inflation, It may be reluctant to raise tax rates and may lack willing lenders - Though a government believe that inflation is the result of the money supply growing faster than output, it can be difficult to control the growth of the money supply as commercial banks have a profit incentive to increase their loans - One of the main influences on the effectiveness of anti-inflationary policies is how households and firms react. o Contractionary monetary and/or fiscal policies may be introduced to lower demand-pull inflation at a time when households and firms are likely to be optimistic about the future. o However, in such a situation,  A rise in the rate of interest, might not reduce consumption and investment.  A rise in income tax rates may cause people to work more hours to maintain their living standards rather than reduce their spending. - Also there is no guarantee that if a government trains or provides subsidies for firms to train workers, that firms will have the capital equipment that can take full advantage of the workers’ new skills. - If productivity of workers rises by less than their wage rates, costs of production will still rise 12  Economics – AL Amali Paththamperuma The Monetary Transmission Mechanism - This is the process by which a change in monetary policy works through the economy via a change in aggregate demand to the price level and the real GDP. - Increase in the money supply may lower the interest rate, which in turn may increase aggregate demand. - Higher aggregate demand may increase output and/or the price level The Liquidity Preference Theory - The demand for money is explained by liquidity preference - There are three main motives for households and firms to hold part of their wealth in a money form o Transactions motive. – interest inelastic  The desire to hold money to make everyday purchases and meet everyday payments.  How much is held by a household or firm is influenced by the income received and the frequency of the income payments.  Generally, the more income received and the more infrequently the payments are received, the higher the amount that will be held o Precautionary motive – interest inelastic  Firms and households hold rather more of their wealth in money form than they anticipate they will spend to meet unexpected expenses, and take advantage of unforeseen bargains.  Money resources held for the transactions and precautionary motives are sometimes referred to as active balances as they are likely to be spent in the near future. o Speculative motive - interest elastic  Households and firms will hold what are sometimes called idle balances when they believe that the returns from holding financial assets are low.  Households and firms are likely to hold money when the price of bonds is high and expected to fall as they will not be forgoing much interest and they will be afraid of making a capital loss.  The speculative demand for money will be low when the price of bonds is low and the rate of interest is high 13  Economics – AL Amali Paththamperuma Interest Rate Determination - Keynesians argue that the rate of interest is determined by the demand for and supply of money. - They assume that the supply of money is determined by the monetary authorities and is fixed in the short run. - The combined transactions, precautionary and speculative motives for holding money in the form of liquidity preference (or demand) for money is shown as below - An increase in the money supply will cause a fall in the rate of interest, 14  Economics – AL Amali Paththamperuma The Liquidity Trap - Although it is expected that an increase in the money supply will cause the rate of interest to fall, Keynes described a situation where it would not be possible to drive down the rate of interest by increasing the money supply. - He described this situation as the liquidity trap. o Occurs when the rate of interest is very low and the price of bonds is very high. o In this case, it is assumed that speculators would expect the price of bonds to fall in the future, so if the money supply was to be increased they would hold all the extra money. o Therefore, they would not buy bonds for fear of making a capital loss, and because the return from holding such securities would be low. Loanable Funds Theory - Theory suggests that the rate of interest is determined by the demand for and supply of loanable funds - The demand for loanable funds is the demand for money to borrow. - The demand for loanable funds slopes down from left to right as borrowing and the rate of interest are inversely related. - The supply of loanable funds comes from savings. - The more money that is saved, the more money there will be available to lend. - The supply of loanable funds curve slopes up from left to right as savings and the rate of interest are directly related. 15  Economics – AL Amali Paththamperuma - The theory suggests that an increase in savings will result in a rise in the supply of loanable funds and a fall in the rate of interest 16