JOHN RAPP

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ECO 204--Part Three Notes

Now comes the second half of macroeconomics.  We look at money and banking, the Federal Reserve 
System, monetary policy, supply side economics and economic growth.  There is a lot of useful information 
about the nation's financial system and the interesting world of the Federal Reserve.  

WEDNESDAY, FEBRUARY 28, 2007

Money and banks

Introduction

The term "money" refers to coins, paper currency in circulation and certain deposits in 
financial institutions.  In everyday usage, people often confuse the term "money" with 
"income."  We observe that someone has a "lot of money," meaning he or she earns a 
large income or has a lot of financial assets.  Don't confuse the two.  Money, as we will 
see, is a medium of exchange--the stuff we use to facilitate economic activity.

Our objectives in the next several classes are to figure out what determines the money 
supply, why it is significant and how banks and the Federal Reserve System administer 
our monetary system.

   

Functions of money

In the United States our money is measured in dollars.  In Mexico, money consists of pesos. 
And in other times and places, dead pigs, salt, tobacco and wampum have served as money.  
For something to serve as money, it must perform three essential functions.

1.  Medium of exchange.  Money has to be accepted by producers and consumers and 
financial institutions.  We have an implicit social contract which says dollars are 
acceptable for making payments, and that we like to receive pay checks denominated in 
dollars.  If money was not a medium of exchange we would have barter.  And with barter 
there has to be a coincidence of wants.  A hungry dentist would have to find a cook with a 
tooth ache and barter to trade services.  Government decrees that dollars are our money, 
but that would be meaningless if we all didn't agree to it.

2.  Standard of value.  This means that money is the standard for measuring prices.  As 
we saw earlier, markets function by determining prices measured in dollars.  If we had a 
barter system with only 1000 items produced, there would have to be 499,500 price ratios.  
There would be a lobster price of haircuts, a pizza price of computer software, and so on.

3.  Store of value.  This means that money maintains its value through time.  We can hold 
on to money and be assured that it will still command goods and services at a later time.  
Inflation impairs this function.

So money exists to facilitate economic activity.  The surprising thing, however, is that money
also influences economic activity.

Definitions of the U. S. money supply

Earlier it was noted that money consists of coins, currency and "certain deposits in financial 
institutions."  There are many kinds of deposits in financial institutions, so the question now 
becomes which ones are included in the money supply.  There are several different money 
supply measures; we will define the two most important--referred to as M1 and M2.  M2 is 
a broader measure and includes more stuff than does M1.

M1 = coins + currency in circulation + transactions accounts + travelers' checks.

What are transactions accounts?  They are anything which permits direct  
payments to a third party.  For the most part, they are checking accounts.  Checking
accounts, in turn, are called "demand deposits" by economists.  That means you
can write a check which withdraws money from your checking account on demand. 
You don't have to notify your bank when you write a check.  In January, 2007, MI
amounted to $1371 billion.

M2 = M1 + savings accounts + some certificates of deposit + money market mutual funds.

A savings account, commonly known as a pass book savings account and called 
"time deposits" by economists, is included in M2 because you can't typically write 
a check against a savings deposit.  A certificate of deposit (CD) is a deposit which 
pays more interest than a savings deposit, but you incur an interest penalty if you 
withdraw the funds before the CD matures.  You can acquire CDs of varying 
maturities--the longer the maturity, the higher the interest rate.  CDs included in
M2 are those which are less than $100,000.  The larger CDs are included in M3, a
still broader money supply measure.  Money market mutual funds occur when a depositor 
essentially gives money for someone to invest in a bunch of different short term debt
instruments.  In some cases it is possible to write checks against money market mutual
funds, depending on the policies of the fund managers.  In December, 2005,  M2 was
$7081 billion--more than four and a half times bigger than M1. 

There are other broader money supply definitions, but our concern focuses on M1 and M2.  
Which is the better measure of the money supply?  There is some difference of opinion but, 
for our purposes, M2 is probably the best money supply measure.

Some basics of the commercial banking system             

The term "bank" is sort of a generic term and is often used to include not only commercial 
banks but also savings and loan associations, credit unions and others.  There are nearly 
8,000 commercial banks which hold the bulk of demand deposits and nearly half of total 
savings deposits.  Banks make loans to consumers and businesses and they provide trust 
services, brokerage services and others.  There are about 500 savings and loan associations 
which specialize in using their deposits to make mortgage loans.  There are nearly 10,000 
credit unions which are cooperatives formed by individuals with some common tie, often their 
employer.  They pool the deposits to make loans to credit union members, typically for 
consumer purchases.  They hold only about five percent of total deposits in the economy.

We will focus on commercial banks because they are the largest of the various types of 
financial institutions, the most diverse and the most significant for public policy.  There 
is not free entry into banking.  All banks must obtain charters from either the federal 
government or a state government. 

If we look at the major segments of the economy--households, business firms and governments--
we will see that some of these segments have surplus funds to lend to segments wishing to borrow 
money.  The lenders and the borrowers are all either households, business firms or governments.  
Financial institutions exist as an expedient way to transfer funds from those wanting to 
lend to those wanting to borrow.  That is significant for public policy, as we shall see.

FRIDAY, MARCH 2, 2007

A bank's balance sheet

Next we look at the major items found on a bank's balance sheet.  A bank's balance sheet serves as 
the foundation for much of our inquiry into how the financial system operates.  Following are the 
major balance sheet accounts:

Vault cash, as its name implies, is the amount of coins and currency a bank has in its vaults--typically not 
very large.  The second asset is deposits at the Federal Reserve.  Banks are required by law to hold a 
certain level of deposits at the Federal Reserve.  Those are assets to the bank just as your deposit at a 
bank is an asset for you.  All banks hold some amount of U. S. government securities.  And banks 
make loans--these are assets because they are essentially a receivable.

The bank's deposits are liabilities because they owe them to their customers and must pay them 
when the customers want.  Demand deposits (or checkable deposits) can be withdrawn simply 
by writing a check.  Time deposits, including CDs, can't be withdrawn with a check but are 
easy to withdraw--even if an interest penalty applies as in the case of CDs.  Banks may have borrowed 
funds from other sources, e.g. other banks or the Federal Reserve System.  Net worth is the difference 
between assets and liabilities and consists of financial capital provided by shareholders plus 
retained earnings.

Back to the assets for a minute.  One of the fundamental management problems a bank faces is 
the trade-off between liquidity and profitability.  What does that mean?  Banks must maintain 
sufficient liquidity to meet possible withdrawal demands by customers.  Vault cash is the base 
line of liquidity.   If a customer comes in and wants to draw down a deposit account for cash, 
the bank must be able to provide the cash.  As noted above, banks don't keep a lot in vault cash.  
But some of the other assets are easily converted to cash.  A deposit at the Federal Reserve is 
very liquid; a bank can quickly get a delivery of cash from the Federal Reserve.  U. S. 
government securities are liquid; they can be sold to others, although this takes a short 
amount of time.  Loans are not liquid at all.  If a bank needs cash, it can't (in most circumstances) 
demand that customers repay their loans immediately.  So as you go down the items in the 
above balance sheet, they go from most liquid to least liquid.  Profitability, however, is the 
opposite.  There is no profitability from vault cash or deposits at the Federal Reserve.  
Government securities are a source of profits, but loans earn higher interest for the bank 
than securities.  So as you move down the items in the balance sheet, they go from least 
profitable to most profitable.  The bank can earn more profits by not being too liquid.  
If a bank has a lot of liquidity, then its profits will be lower.  The optimum trade off is a 
real management issue for a bank.

Technique of bank balance sheet changes

A technique we often use is to analyze transactions which change the major items in a 
bank's balance sheet.  Three examples are given below.

1.  A customer withdraws $100 in cash from a demand deposit account.

2.  A bank buys a $10,000 government security from a customer.

Sometimes a bank customer has a U. S. government security, but does not 
want to hold it until it matures.  So (and this is a routine transaction) the 
customer takes the security to a bank and sells it to the bank for its market 
price.  How does the bank pay for the security?  It simply credits a demand 
deposit account (or some other deposit account) for the market value of 
the security.  Here are the entries:

3.  I borrow $1.4 billion from my bank!

I sign a note agreeing to pay back the $1.4 billion at some point in time.  The 
bank now has an increase in its loans--receivables.  How does the bank give 
me the $1.4 billion?  It could give it to me in cash, but that's not typical.  
What normally happens is that the bank increases my deposits by the amount 
of the loan--I get the proceeds in the form of a deposit slip:

Fractional reserve banking

We need to talk about those deposits banks hold with the Federal Reserve System (Fed).  By 
law, all financial institutions must maintain reserves.  Legal reserves are the sum of vault 
cash plus deposits at the Fed.  These reserves are a percentage of deposits.  So the more 
deposits a bank has, the larger its required reserves.  Most banks currently must maintain 
reserves equal to ten percent of their transactions deposits.  Typically banks have more 
than what is legally required.  This gives rise to three important definitions:

 

 How are checks cleared?

Before we can fully understand about banks and the Fed, we have to understand how 
a routine process works.  If you write me a check for, say, $100 you know that somehow 
that check will be "cleared"--i.e. charged to your account.  How does this happen?  How does 
that check ultimately get subtracted from your account?  One of the service functions provided 
by the Fed is to clear checks.  We will use bank balance sheet changes to figure out what 
happens, and assume that we bank in different banks. The following entries are the result 
of this process, explained below:

You give my the check and I deposit it in my bank.  My bank increases my deposits by $100.  
What does my bank do with the check.  It sends it to the Federal Reserve (Fed) and deposits 
it to its account in the Fed.  That shows above as an increase in Fed deposits for my bank.  
What does the Fed do with the check?  It charges your bank the $100 amount of the check 
and that's why your bank has a $100 decrease in its deposit at the Fed.  Finally, the check 
is physically sent to your bank which reduces your deposit by the $100.  You knew that 
would be the outcome, but you probably didn't know how the Fed plays a role in clearing 
the check.  

How much can a bank loan?

Here's the principle: 

A bank can expand its loans by the amount of its excess reserves, but no more 
than that amount.

This is a bit laborious, but it's critical to understanding how banks operate and how the 
Fed administers monetary policy.

Suppose, at some point in time, the balance sheet of the Last National Bank contains the 
following amounts.  Now not all the accounts are shown--if they were, the balance sheet 
would of course balance.  I am showing only those relevant to bank lending.  (The dollar 
amounts are low for simplification--you can think of the dollar amounts as being in millions 
or billions or zillions or whatever.) 

How much does the bank have in excess reserves?  Its deposits are $1000, so its required 
reserves are $100 (again, assuming a 10 percent reserve requirement).  It has $200 in  
total reserves (vault cash plus deposits at the fed).  So its excess reserves are $100.  
Now, to get at the proposition above about excess reserves, what if the bank lends 
that $100 in excess reserves to a customer?  Typically when a bank makes a loan to 
someone, the proceeds are given to the customer in the form of an increased deposit.  
If you borrow $100 from a bank, you walk out of the bank with a deposit slip for $100.  
Catch this:

The U. S. money supply increases when someone borrows money.  
The customer leaves the bank with a deposit-- which is an increase 
in the money supply.  BUT money has been created.  The borrower 
has $100 more, but no one has any less.  HENCE THE BANK LITERALLY 
CREATED MONEY!  Banks don't lend "your" money to someone else; 
new money is created when a loan is made.  REMEMBER THAT.

Now the loan is made.  So what happens to the balance sheet of the Last National Bank?  Initially 
loans increase from $500 to $600 and deposits increase from $1000 to $1100.  Then what?  
Whoever borrowed the $100 will spend it on something.  Most people don't borrow money just to 
keep it in a deposit account!  So the borrower spends it--by writing a check.  What happens when 
that check clears?  You remember that.  It's deposits and reserves are decreased by $100.  
Now what does the Last National Bank's balance sheet look like?  Put all this together, and here
are the balance sheet amounts now:

Look!  The Last National Bank now has deposits of $1000 (because the loan proceeds were spent 
and the check cleared).  Its reserves are $100 and it has no excess reserves.  The initial excess 
reserves were $100 and, when the bank made a loan of $100, the excess reserves fell by $100.  
Now its excess reserves are zero and it can't make any more loans.  If it loaned another $100, 
it would have negative excess reserves and that isn't legal.  So, once again--A bank can expand 
its loans by the amount of its excess reserves, but no more than that amount.

Something, however, is left over from this . . .

MONDAY, MARCH 5, 2007

No one ever said understanding the subtleties of banking is easy!  So what's the left over??

Loan and deposit expansion: the whole banking system

In that last example, remember about check clearing.  The Last National Bank had $100 in 
excess reserves, and it made a $100 loan.  The check written to spend the proceeds was received 
by someone who deposited it in another bank.  (It could be deposited in the same bank, but 
the net effect is the same.)  Suppose whoever received that check then deposits it in the 
Next to the Last National Bank.  The Next to the Last National Bank will have an increase in 
its excess reserves of $90 which it can then lend to someone else.  Do you begin to see what's 
happening?  The Third to the last National Bank receives additional excess reserves of $81 which 
it can lend.  And we have sort of a chain reaction going on. Look carefully at the table below.   
It assumes that Bank A (formerly known as the Last National Bank--but that wording can get 
awkward) initially has excess reserves of $100 which it lends.  Bank B (formerly known as the 
Next to the Last National bank) gets new deposits of $100, an increase in its reserve requirement 
of $10 and new excess reserves of $90 which it loans out, and so on.  In the table below, D stands 
for deposits, AR is actual reserves, RR is required reserves, ER is excess reserves and L stands 
for loans:

The second row in the table shows the initial $100 in excess reserves held by Bank A which 
it lends.  Bank B then has an increase of $100 in its deposits and its actual reserves, a 
resulting $10 increase in required reserves and a $90 increase in its excess reserves 
which it then lends.  Follow across the rows and make sure you understand the entries.  
If this process continued until there was nothing left, there would be $1000 in new 
deposits--and hence a $1000 increase in the money supply--and $1000 in new loans, 
shown in the last row of the table.  How did I get that?

The money multiplier

Notice that the banking system started with $100 in excess reserves and ended up 
with $1000 in new deposits and loans.  There was a money multiplier of 10--i.e. the 
increase in the money supply was 10 times as much as the initial amount of excess 
reserves.  The size of that multiplier depends on the required reserve ratio.  If 
required reserves were 20 percent, the increase in the money supply would be smaller.  
The value of the money multiplier is equal to one divided by the required reserve ratio 
(expressed as a decimal). So in the table above the money multiplier is 1/.1 = 10.  If 
the required reserve ratio was 20 percent, the money multiplier would be 1/.2 = 5.  
(You don't need to worry about how that formula is derived.)   

The formula is simplified and an actual, real world multiplier is more like 2.  Why?  
Banks may not always be fully loaned up.  Some of the newly created deposits might 
be taken out in the form of cash withdrawals.  There are many different kinds of 
deposits in the financial system; in the illustration above we assumed just one kind 
of checkable deposit.  These and other things lead to an actual value considerably 
smaller than our illustration.  But there is a money multiplier--be careful not to 
confuse this with the investment and government multipliers we talked about earlier.

"Behavioral" aspects of bank lending

That's me running away from the Walden National Bank!

What's going on here?  If the Walden National Bank did not have any excess reserves--
and if what we looked at earlier about excess reserves and loans is true--how could I 
expect the bank to extend a loan to me?  The discussion about excess reserves and 
lending implies that banks adjust their loans to their reserves.  That's not how banks 
behave.  What they do is adjust their reserves to their loans.  What would most likely 
happen at the Walden Bank is that I would get my $500,000 loan. (Remember, I am 
very rich.)  That would cause the bank to be short of reserves, so what the banker 
does is immediately try to acquire additional reserves to cover the loan they made to 
me.  That's part of how to manage a bank.

How does a banker acquire additional reserves to cover new loans?  There are three 
possibilities.  One is to borrow from the Federal Reserve.  The Federal Reserve can 
make loans to banks, although they don't really make very many loans to banks.  
Sometimes the Fed is regarded as the lender of last resort.  So, although possible, 
that's what typically happens.  A second possibility is for the bank to sell some of 
its government securities and deposit the proceeds with the Fed.  That would 
increase actual and excess reserves.  But, government securities are a source of 
earnings for the bank so that isn't done too often.

What typically happens is that banks who are short of reserves borrow reserves from 
banks that have more reserves than they need.  These are overnight loans.  The Walden 
bank would borrow from some other bank to cover the loan they made to me and then 
repay the loan the next day, including interest.   On any given day, some banks will 
face a reserve shortage while others have a reserve surplus.  That depends on the 
dollar value of checks are written against a bank and the dollar value of checks 
deposited in a bank.  This is a computerized market and it's called the Federal 
Funds market.  That's an odd term; it is shorthand for Federal Reserve funds.  The 
interest rate is the federal funds rate and, as we will see later, the Fed is very 
interested in the federal funds rate.  It is an important part of monetary policy.

A comment on bank failures

Banks, like any private business, can and do fail.  During the great depression of the 
1930s, over 9000 banks failed.  In the 1970s a number of savings and loans also failed.  
Depositors, however, do not assume any risk with a bank, because bank deposits are 
insured by the Federal Deposit Insurance Corporation (FDIC) for deposits up to $100,000. 
That was started by Congress during the great depression.  Banks pay premiums for 
this insurance to the FDIC--but those premiums aren't adjusted for how many risky loans 
a bank makes.  Many think the premiums should be risk adjusted.  Savings and loans 
are insured by the Federal Savings and Loan Insurance Corporation (FSLIC).  When 
many of them failed in the 1970s, the FSLIC ran out of funds and the federal government 
paid for costly bail outs.  

The Federal Reserve System 

Now we turn our attention to the sometimes mysterious world of the Federal Reserve.  
The Fed was created by Congress in 1913.  It is a central bank, and it is a bankers' bank.  
Banks do the same kinds of business with the Fed that you and I do with a commercial 
bank.  They keep deposits there and they can, as noted above, borrow from the Fed.  
Broadly speaking, there are two purposes of the Fed.  One is service functions and the 
other, more importantly for us, is monetary control.  Unlike other government agencies, 
there are no checks and balances for the Federal Reserve.  Neither the Congress nor 
the president can veto their actions.  They play a role in determining who the board 
members are, as noted below.  But that's all.  I guess in one sense Congress could 
play a role.  Congress created the Fed, so it could get rid of it or modify its structure--
but there is a near zero chance of that happening.

Functions of the Fed

We look briefly at the Fed's main functions:

• Clearing checks, as we saw earlier
• Holding bank reserves, as we also saw earlier
• Providing currency
• Making loans to banks (sometimes)
• Supervising and regulating banks
• Framing and executing monetary policy
  
  

The currency you carry says "Federal Reserve Note" on it.  The currency is a liability 
of the Federal Reserve, although you can't redeem it for anything.  It used to be that 
there had to be gold backing part of the currency, but not any more.  As we saw 
earlier, currency discharges its functions because we have confidence that 
it will.

How is the Fed organized?

At the top of the Fed's structure is the board of governors.  The board consists of 
seven members, appointed by the president with the consent of the senate.  They 
are appointed for fourteen year terms so a newly elected president cannot simply 
sweep them all away and appoint members of his own choosing.  A member cannot 
be reappointed to a second fourteen year term, however.  They can only by removed
by impeachment, which has never happened.  This insulates the board from 
political whims.  

One of the board members is the chair.  He or she is also appointed by the president 
with the consent of the senate.  The chair is appointed for a four year term, and is 
regarded by many as a person of great economic power--more than the president.  
For almost 20 years, the chair of the board was Alan Greenspan--a colorful person 
and one generally held in high esteem by most.  He was appointed in 1987 by President 
Reagan to fill an unexpired term.  He was reappointed chair by Bush, Clinton and Bush II. 
Greenspan has a doctorate in economics, as do six of the seven governors. The 
current chair, appointed last year to that position, is Ben Bernanke. 

There are twelve regional federal reserve banks.  So we have a sort of decentralized 
central bank.  The twelve regional banks primarily perform service functions for their 
district.  The most important policy making group in the Fed is the Federal Open 
Market Committee (FOMC).  It consists of the seven members of the board of 
governors, the president of the Federal Reserve Bank of New York and four other 
presidents of regional federal reserve banks.  The latter rotate among the other 
eleven regional banks.

WEDNESDAY, MARCH 7, 2007

Tools of monetary control

We now need to understand exactly how the Fed controls the money supply.  It can 
control it--make no mistake about that.  But how?  Once we understand how, then 
we turn to the "so what" question.  Why does the size of the money supply matter?  
First let's see how the Fed controls money.  There are three broad tools available 
to the Fed to control the size of the money supply.

1. Reserve requirements

There is a range within which the board of governors can set reserve requirements. 
That range, in turn, is set by Congress.  What would happen if the board of governors 
lowers reserve requirements.  That would raise excess reserves and increase the size 
of the money multiplier and would be regarded as an expansionary policy--one the Fed 
might use to fight recession.  Look at the calculations in the table below to see why 
this is so:

The second column shows what happens with a reserve requirement of 20 percent.  It is 
assumed that there are total deposits of $100 (billion or zillion or whatever) and total 
reserves of $25.  Now with a reserve requirement of 20 percent, required reserves are 
$20 and excess reserves are $5.  The money multiplier is equal to 5 (1/.2 = 5).  
The amount available for loans is the $5 in excess reserves times the money multiplier 
of 5 which gives an amount of $25.  Now the far right column shows what happens 
when reserve requirements are reduced to 10 percent. We retain the assumptions 
of $100 in deposits and $25 in reserves.   Follow down the rest of that column and 
you will see that the total amount available for loans rises from $25 with a 
20 percent reserve requirement to $150 with a 10 percent reserve requirement.

Increasing reserve requirements would have exactly the opposite effect and would 
reduce the size of the money supply.  Changing reserve requirements is potentially 
very powerful, BUT the Fed almost never uses it!  It's an abrupt policy that would 
change the amount available for loans immediately.  That could be disruptive to 
financial markets, so the Fed doesn't typically do this.

2.  Interest rates

Discount rate

The discount rate is the rate the Fed charges when it loans money to a bank.  
(The term discount rate is an old term.  It used to be that banks had to 
provide collateral when borrowing from the Fed.  When that happened, it 
was called "discounting."  Banks no longer have to provide collateral, but 
the term stuck.)  Since World War II, the discount rate has varied from 
0.75 percent to 14 percent.  It's currently 6.25 percent, having been increased 
many times since mid-2004.

When the Fed increases the discount rate, bank borrowing from the Fed is 
discouraged because it's more expensive for banks to obtain additional excess 
reserves.  This would be done to combat potential inflation.  A decrease in 
the discount rate encourages bank borrowing and is therefore an expansionary 
policy used to fight recession.

BUT remember--the Fed doesn't lend very much to banks and banks don't like to 
borrow from the Fed.  The total volume of lending is rarely over $2 billion.  So 
what's with the discount rate?  It's largely symbolic.  It predicts other policy 
maneuvers, especially #3 below.

Federal funds rate

As noted earlier, the federal funds rate is the rate charged banks for over night 
borrowing in the federal funds market.  Currently the target rate is 5.25 percent, 
also having been increased many times since mid-2004.  The Federal Reserve 
"targets" a federal funds rate.  The Fed doesn't set the rate, because it is 
a market determined rate.  If the Fed wants to tighten credit to reduce 
inflation concerns, it targets a higher federal funds rate.  How do they try 
to achieve the target rate?  They use--guess what--policy maneuver #3, to 
be discussed shortly.  It has the same general effect as the discount rate, 
i.e. a higher rate makes banks less likely to borrow which curtails credit 
expansion.

"Announcement effects"

If the Fed cuts the discount rate or the target federal funds rate, it doesn't
have much effect in its own right.  But, as soon as a change in either rate is
announced, the market will anticipate that the Fed is going to do other things
to change market interest rates.  When the discount rate or the target federal
funds rate rises, for example, banks often increase prime rates (and others)
immediately--in anticipation that the Fed will undertake other actions to ensure
increases in economy wide interest rates.  These two interest rates are changed
as an indicator of future Federal Reserve "open market" policy.

3.  Open market operations

It's called open market operations.  And it is very important.  What's the open market? 
It's the secondary market where government securities are bought and sold.  If I buy a
security from the federal government (to help finance or refinance the public debt),
I may decide to sell that security before it matures.  If I do, I go to the "open market"
and sell it for its market price.  The Fed, through about 36 private government securities
dealers, buys and sells securities.  This, as we will see, affects the money supply and
interest rates.  These decisions are made by the Federal Open Market Committee, which
was described earlier.  It certainly doesn't sound like a powerful tool of monetary control, 
but it is the most powerful tool, as we are about to see.

Open market purchases

Suppose the Fed goes to one of those government security dealers and purchases 
$1 million in government securities.  What happens?  We will number these transactions 
to correspond to the balance sheet entries below.  (1) The Fed now has the securities 
which is an addition to its assets.  How does the Fed pay the dealers?  It simply writes 
a check and gives it to the government security dealer.  What does the dealer do 
with the check?  (2) It deposits it in a commercial bank.  What does the bank do 
with the check now?  (3)  The bank deposits the check in its account at the Federal 
Reserve.  (4) When the bank does that, the Fed increases its deposit liabilities.   
Follow these transactions in the following balance sheet change entries:

Look now at the reserve position of the commercial banking system.  It has $1 million 
more in reserves as shown in (3) above.  Because it's deposits have increased, (2) 
above, it faces a larger reserve requirement.  If the reserve requirement is ten 
percent, banks will have to have a larger required reserve of $100,000.  It has 
that and more.  The banking system's excess reserves have increased by 
$900,000--and that enables banks to expand loans and consequently the 
money supply will increase. 

Put this together with what we said about about interest rates.  If the Fed reduces 
the discount rate and/or the federal funds target rate, interest rates would go 
down quickly via announcement effects.  Later on the Fed engages in open market 
purchases.  That increases the money supply--and an increase in the money supply 
will in fact lower interest rates.  (That latter point comes up next time but, 
intuitively, more credit availability would lower rates.)

One important point remains.  The Fed paid the government securities dealer by 
drawing a check on itself.  Is there any limit on the Fed's doing this?  Does the 
Fed face any kind of reserve requirement? 

The Fed can write as many checks against itself as it wants.  There is no limit of 
any kind on the Fed's ability to do this.  The Federal Reserve can create as much 
money as it wants.  That is why open market operations are so powerful!

Open market sales

Open market sales work exactly the reverse of the above.  This will not be spelled 
out in these notes, but it should be pretty clear.  Open market sales reduce the 
banking system's deposits and its legal reserves and, therefore, its excess reserves.  
Open market sales would lead to a decrease in the money supply--and, as we will 
see, higher interest rates.

Some final additional notes about monetary control

• Note again that a change in the discount rate or the federal funds target rate
  predicts a change in open market policy.
  
  
• The significant thing is the rate of increase in the money supply.  Seldom, if
  ever, does the Fed try to reduce absolutely the size of the money supply.
  
  
• Notice the important role of the multiple expansion of deposits in the banking
  system and the unlimited ability of the Fed to create new reserves.  Remember,
  also, that no one can veto Federal Reserve actions.
  
  
• There is an issue as to whether to Federal Open Market Committee should
  focus on interest rate targets or on money supply targets.  They are related
  but, as we will see, there is an important difference.
  
  
• So, can the Fed control the money supply?  Not perfectly, but they are certainly
  the major influence on the money supply.

Answers to quiz #4 March 7, 2007--10:00 section 1.  false        6.   C 2.  false        7.   B 3.  C             8.   B 4.  B             9.   D 5.  C            10.  B

Answers to quiz #4 March 7, 2007--1:00 section 1.  true          6.   C 2.  true          7.   D 3.  A              8.   B 4.  A              9.   A 5.  C             10.  C

FRIDAY, MARCH 9, 2007

Now you have an idea about what determines the size of the money supply, and how its rate of growth 
is determined.  The next question is: So what?  Why does the quantity of money make any difference to 
the major macro variables of income, employment and prices?  We will see controversy here.  Keynes did 
not think money was of any particular significance.  Monetarists certainly do; they think money and 
monetary policy are far more significant than fiscal policy.

The money market

First we look at the money market.  We already know that the supply of money is largely determined 
by the Federal Reserve.  There is also a demand to hold money.  Why do people want to hold 
part of their wealth in the form of money?  It earns little or no interest.  Stock, bonds and other 
financial assets do earn significant interest.  It may be intuitive to you, but we look shortly at 
the reasons for holding money as opposed to other financial assets.

There is a supply of money and a demand for money.  It is interest rates that determine equilibrium 
in the money market--interest rates equate the Fed's supply of money with peoples' demand for money.  
We need to make two important distinctions about interest rates before we examine the demand 
for money and money market equilibrium.

The demand for money

Although Keynes did not think the quantity of money to be of much importance, he did 
identify three reasons why people hold money--or, as he called it, idle cash balances--
rather than more lucrative financial assets.

Transactions demand

An obvious reason is that people hold money to finance day to day transactions--e.g. 
groceries, gasoline, movies, etc.  It would be difficult to use a checking account to 
purchase a candy bar from a vending machine!

Precautionary demand

People hold some money for the proverbial rainy day.  An emergency might arise, or 
future income for a household might unexpectedly fall.

Speculative demand

Some hold money to have it available for acquiring financial investments later on.  
How much people hold for speculative purposes depends on a number of things, but interest
rates are especially important.  If rates are high, people will not hold as much for speculative
purposes because they will want to take advantage of relatively high interest rates.

TOTAL demand for money

If we add together the three reasons for holding money, what does the market 
demand for money look like as a function of interest rates?  The answer is that 
the demand for money and interest rates are inversely related.  It is clear that 
higher interest rates will induce people to hold smaller speculative demand balances; 
they will want to invest idle cash balances to reap the benefits of higher rates.  
Households and businesses hold less money when rates rise because the opportunity 
cost of holding cash rises as interest rates rise.

Equilibrium in the money market

This is easy to describe.  The supply of money shown below is vertical, reflecting 
the assumption that the Fed determines the supply of money at any point in time.  
The demand for money is negatively sloped and equilibrium is where the supply 
(S_M) and demand (D_M) are equated.  The symbol "r" stands for interest rates--
an average, or index number, of the many different rates.

Looking at the above diagram, suppose the Fed increases the supply of money 
by engaging in open market purchases.  The equilibrium real rate of interest will 
fall.  BUT, if the increase in money produces inflation (and we will talk about that 
later on), then nominal interest rates will rise.  This can be tricky, but it's important.  
Note also that if the Fed cuts the discount rate and/or the federal funds target rate, 
then it engages in open market purchases to increase the money supply, then 
other rates also fall.  That ties together the earlier discussion about how the 
Fed manipulates interest rates.

How do money supply changes affect output and prices?

The basic idea can be stated as follows:

where S_M stands for the supply of money, r is for interest rates, I for investment, Y for 
output (or income) and P for the price level.

So if the money supply increases, that will lead to a decrease in interest rates which, in turn 
will increase investment.  The increase in investment shifts aggregate demand to the right 
and that results in an increase in output and in prices.  This would be a monetary policy 
designed to fight recession.  The following diagrams show how an increase in the money 
supply effects investment, the first three parts of the above cause and effect chain:

When the supply of money increases, interest rates decrease--as shown in the graph on the left.  
The lower interest rates call further greater investment, as shown in the graph on the right.  
If investment increases, then--you know the rest--aggregate demand increases which increases 
both output and prices.

Presumably the opposite of all the above would hold for fighting inflation.  Keynes first set forth the 
above relationships, but he did not talk much about fighting inflation--as we have noted several times 
before.  Even though the above makes sense, Keynes saw some real limitations to fighting recession 
using money supply changes.  Keynes, in The General Theory, said this:

(That quote also reflects Keynes' style of writing!)

Limitations to monetary policy--a la Keynes

What are these "slips?"  The first has to do with the responsiveness of the demand for 
money to changes in interest rates.  Keynes believed that at very low rates of interest, 
the demand for money would become perfectly elastic.  With low interest rates, 
the opportunity cost of holding cash is so low that everyone elects cash over other 
financial assets.

The second slip has to do with the responsiveness of investment to changes in interest 
rates.  Earlier we noted that Keynes thought expectations were extremely important 
in determining investment.  He also thought that lower interest rates would call 
forth more investment--but not very much more.  So even if the economy was 
not in the liquidity trap, a reduction in interest rates would not have a 
significant impact on investment.  These two weak links in the earlier reasoning 
chain show why Keynes did not think monetary policy to be of much significance.

Monetarist analysis

Now we come to the second major theory of macro economic behavior, the monetarists.  
As we noted earlier they think that monetary policy is of great importance--and that fiscal 
policy is not especially helpful.  Monetarists utilize a phenomenon called the "equation of 
exchange" to outline their thoughts.  They can use the aggregate demand and aggregate 
supply model, but the equation of exchange facilitates an easier understanding of what 
monetarists are saying.

The equation of exchange

Here is what the equation of exchange looks like:

The only term in the equation of exchange not familiar to you is V, the income velocity of 
money.  Income velocity is defined as the average number of times per year each dollar 
in the money supply is spent on things included in GDP.  If I buy something from you for 
$1 and you take that $1 and buy something from another person, then velocity would be 2.  
We count only transactions included in GDP; we don't count used goods or services.  
We do this for a year and that gives us velocity--or the rate of turnover of each 
dollar in the money supply.  So what happens when we multiply M times V?  It gives 
us the amount of total spending in the economy.  If M equals $100 and V equals 5, 
then M times V is $500 and that would measure total spending in the economy.

What is P times Q?  That's also a measure of total spending.  If the price level is 2 
and real output is $250, P times Q is $500--which is also a measure of total spending.  
Hence the "equation," (which really is a truism, not an equation) is true by definition.  
Also note that P times Q is a measure of nominal income; so is M times V.  (Note that 
we could use the M1 measure of the money supply; that would have a V1 measure of 
velocity.  We could also use the M2 measure of the money supply and have a V2 
measure of velocity.  We will use the M2 and V2 concepts.) 

Now, note this:  If M increases, by definition, either V must decrease, P must increase, 
Q must increase--or some combination of all three.

Monetarist propositions

Monetarist propositions can be succinctly stated as follows:

Consider this: IF velocity is constant and IF the Fed controls the money supply, then a 
change in M would have to cause changes in P and/or Q.  Monetarists do not think you 
need to trace the effects of a change in M via interest rate effects, as Keynesians do.  
Monetarists think the Fed should keep its eyes on the money supply--and not on interest 
rates.  There is a dilemma here, however.   In recent years, the Fed has controlled 
interest rates (against monetarist advice) and the economy has performed very well.  
 

MONDAY, MARCH 19, 2007

Is velocity stable?

Part of the validity of the monetarist propositions, stated above, depends on the behavior 
of velocity.  Is velocity constant?  No.  Is it relatively stable?  Yes--especially in the long run.  
Consider the behavior of velocity from 1980 through the present.  The lowest value (for V2) 
was 1.62 in 1986 and the highest was a little over 2.0 in 1997.  Currently, velocity is 1.87.

Keynesians say this is unstable; they also say that changes in M cause changes in V, 
but they don't say how.  Monetarists say that velocity is sufficiently stable to validate 
their propositions stated above.  Now we have to talk about HOW monetarists think 
that money supply changes are transmitted to output and prices.

Money, prices and income

Given that velocity is relatively stable--and the data above--changes in the money 
supply must affect both P and Q.  The equation of exchange itself doesn't permit us 
to say if that effect will be greater on P or on Q.  But monetarists argue that any 
significant increase in money must eventually lead to an increase in prices.  Why?  
Remember the process--increases in the money supply occur through banks' lending.  
And when households or businesses borrow, they spend.  Spending shifts aggregate 
demand to the right, so that prices will inevitably rise.

Monetarists draw a lot on history to support their views.  Going back to 1875, 
changes in nominal income and prices have closely followed changes in the money 
supply.  The relation between money and prices is especially strong.  Every major 
increase in money has been followed by major inflation.  And every decrease in 
the money supply has been followed by deflation.  This includes periods of war, 
depressions, and every other period.  One of the biggest proponents of monetarism 
is Professor Milton Friedman, a University of Chicago economist and a Nobel 
Laureate. Friedman offers a simple conclusion that "Inflation is always and 
everywhere a monetary phenomenon."  Other things--e.g. labor unions, powerful 
business firms, fiscal policy--are not the common element in inflation.  Only 
the money supply is.  So, put simply, monetarists contend that inflation will occur 
when the Fed lets the money supply grow too rapidly.  If that happens, the remedy 
is to reduce the rate of growth in the money supply.  A 1997 empirical study
by the Federal Reserve Bank of St. Louis confirms Friedman's statement.  
Going back to the mid 1870s, that study concluded that inflation has always 
been a monetary phenomenon. 

If we are in recession, would monetarists then contend that expanding the money 
supply would be helpful?  Yes, but if money increases too rapidly then, later on, 
inflation occurs. 

Money and interest rates

Remember the distinction between nominal and real interest rates.  Real interest 
rates are calculated by subtracting the rate of inflation from a nominal interest rate.  
Monetarists see real rates as fairly stable.  An increase in the money supply will lower 
real interest rates somewhat.  BUT if money growth leads eventually to inflation, 
then nominal rates will rise.  High nominal rates are a symptom of inflation--not 
a cause of it.  Inflation is caused by increasing money too rapidly.

What about the long run?

In the statement of monetarist propositions, it was noted that in the long run 
monetarists do not think that money affects real output.  Why not?   They believe 
that in the long run real output depends on structural factors--e.g. labor market 
efficiency, production capacity, technology and numerous others.  In the long 
run they believe that, at any point in time, aggregate supply is perfectly 
vertical and that changes in aggregate demand would change only the price 
level--and therefore nominal output--but not real output.  The following diagram 
illustrates this:

The shift to the right of AD results only in an increase in the price level.

Time lags in monetary policy

Monetary policy becomes much more complicated when we account for time lags.  There 
are three major time lags, as follows:

For monetarists, these time lags often result in considerable over-reaction.  What does 
that mean?  Suppose we are in a recession, and the Fed decides to increase the money 
supply.  It does that; time passes; but output has not yet risen and unemployment has 
not yet fallen--because of the time lags.  The temptation is to increase the money 
supply still more.  Meanwhile, the recession ends, but the earlier increases in the 
money supply leads to inflation.  Now we need restrictive  money growth and that 
can lead to recession later on.  And a vicious circle is in the making.  How do 
monetarists react to all this.  It leads them to produce an "automatic monetary 
pilot," which means . . .

The constant money growth proposal

The final point we make about monetarists is their proposal that the money supply 
should grow at a constant annual rate, probably in the range of three percent--the 
same as the long run growth in real output.  This would eliminate discretionary 
monetary policy.  The Fed would be required to ensure constant money growth--
which would surely irritate Chairman Bernanke!

What are the advantages of the constant money growth proposal?

• It would ensure stable prices, so that decisions are made on the basis of real
  production relationships, not fluctuating prices.
  
  
• It does away with the over-reaction problem.
  
  
• If the quantity of money is the chief short run destabilizing problem, then that cause is
  eliminated.
  
  
• It focuses on money growth--not interest rates.

Is there a "second best" solution?  Yeah--the more stable monetary growth, the better!  
Does this proposal make sense?  Certainly the Fed would not like selling out to this 
proposal--but many think it makes economic sense. 

WEDNESDAY, MARCH 21, 2007

We interrupt these notes to bring you two bad jokes about economists! How many Federal Reserve economists does it take to screw in a light bulb? Only one--he holds the light bulb and the whole earth revolves around him. Two economics faculty meet in the lunch room.  One inquires, "How's your wife?"  The other responds, "Relative to what?"

Supply side economics

We begin our inquiry into supply side economics by looking at three contrasting views of 
aggregate supply:

Although not stated earlier, Keynesians really don't think prices are affected much unless 
the economy is at capacity.  So they really picture a horizontal AS curve until capacity is 
reached, and then it becomes vertical.  Monetarists, as we noted earlier, view AS as 
vertical in the long run.  Supply siders view AS much as we have drawn it earlier--
upward sloping.

Supply siders see a real problem with Keynesian fiscal policy or monetarist monetary policy.  
If you shift aggregate demand to the right to fight inflation,  you get a larger output--but 
also a higher price level.  If you shift aggregate demand to the left to fight inflation, you 
get a lower price level but also more unemployment.  They always see a problem with 
fighting macro problems by shifting aggregate demand.

The Phillips curve

Supply siders illustrate this aggregate demand problem with a Phillips curve (named 
for the economist who first articulated it).  It shows a trade-off between inflation 
and the rate of unemployment:

If unemployment falls, inflation rises.  If inflation falls, unemployment rises.  If you 
have a moderate amount of both inflation and unemployment, that is stagflation.  
Supply siders use this curve as a summary of why designing policies to affect 
aggregate demand are a poor idea.

Unfortunately, the Phillips curve is not stable.  It shifted to the right from the 1960s to 
the early 1980s.  That makes things still worse.  Critics of the supply side approach say 
that it is so unstable that it is not reliable for designing public policy.  Nevertheless, 
supply siders adhere to it.  They also employ a misery index:

the sum of the inflation
rate and the unemployment rate.

There is nothing scientific about this at all, but they refer to it anyway.  In 1980, the misery 
index was 19.6,  Currently it is 6.7.  (The unemployment rate is 4.6 percent and the inflation
rate is 2.1 percent.) 

So what are the objectives of government policy for supply siders?   Broadly speaking, 
there are three:

1. Shift aggregate supply to the right to increase output and reduce inflation.
   

2. Shift the Phillips curve to the left.
   

3. Reduce the size of the misery index.

Supply side policies

Tax cuts

Supply siders believe that the most appropriate public policy is to cut marginal tax rates.  
This shifts aggregate supply to the right, increases output--and does so without inflation.  
Lower marginal rates boost incentives for people to work and for businesses to save.  
They believe high marginal rates involve strong disincentives for people to work and 
for businesses to invest.

Although their primary emphasis is on shifting aggregate supply, they also believe 
cutting taxes impacts aggregate demand.  How?  By stimulating saving which makes 
possible more investment in the long run.

Keynesians also argued for tax cuts as a stimulus to promote recovery from recession, 
but for very different reasons.  Keynesians argue that tax cuts lead to larger disposable 
income and therefore greater consumption, which shifts aggregate demand to 
the right.  Their reasoning is much different than for supply siders.

The Laffer curve

Another relationship stressed by supply side economists is the relation between tax 
rates and tax revenues.  That is depicted in the following diagram:

We looked at this earlier when we talked about how lower tax rates have often led
to higher tax receipts and vice versa.  The curve shows that as tax rates increase,
so do tax revenues--up to point F.  If tax rates go higher than that, tax revenues
decline.  The optimal point for government is F; that's where government maximizes
its revenue.  Any rates above F--in the yellow zone--are clearly undesirable.

Is this curve for real?  Yes.  Historically that relationship has been shown to hold. 
The problem is no one knows where on the curve the economy is at any given point in
time.  President Reagan used the Laffer curve to help sell his tax cuts in the 1980s.

Deregulation

Another strong policy proposal is to engage in more deregulation of business
 firms.  They argue that the cost of regulation is outrageously high and this 
is detrimental to growth.  They oppose such things as minimum wage 
laws, mandatory fringe benefits, OSHA regulations, EPA regulations, 
tariffs, and excessive transfer payments.

Improve human capital

Supply siders are also favorably inclined toward programs which provide 
education and worker training.  Some of them also favor affirmative 
action as a means of improving human capital.

Infrastructure improvements

Finally they are proponents of improving the economy's infrastructure--e.g. 
highways, high speed rail, satellite communication, hospitals and 
schools.  These programs, they argue, will enhance efficiency and 
further boost aggregate supply to the right.

Answers to quiz #5 March 21, 2007--10:00 section 1.   true          6.  E   2.   false         7.  D  3.   D              8.  C  4.   B              9.  E  5.   A             10. B

Answers to quiz #5 March 21, 2007--1:00 section 1.  true          6.   A 2.  false         7.   B 3.  C              8.   A 4.  B              9.   B 5.  D            10.   B

 

FRIDAY, MARCH 23, 2007

Economic growth

We have now completed our survey of the basic theories of the macro economy.  Now we look at 
another macro economic goal, that being economic growth.  Then, after the third test, we spend 
the last one fourth of the course on international economics.

A few basics

When we talk about economic growth, we are primarily talking about the level of real GDP 
or real GDP per capita.  For growth to occur output must grow more rapidly than 
population.  Basically, growth comes from expanding our capacity--shifting the 
aggregate supply curve to the right through time--and from better utilization of 
our resources.

A growth rate, like any other rate, compounds over time.  Consider the following:

• A growth rate of 1 percent per year will double GDP in 70 years.
  
  
• A growth rate of 3 percent per year will double GDP in 24 years.
  
  
• A growth rate of 5 percent per year will double GDP in 14 years.

In the United States, our average rate of growth in real GDP over the last century 
has been right at 3.3 percent per year.  But growth has slowed down from the 1960s 
until the late 1990s. In the decade of the 1960s, the growth rate averaged 
4.1 percent per year.  In the 1970s, that rate fell to an average of 2.8 percent per 
year--and then to 2.5 percent in the 1980s and to 2.3 percent from 1990 through 
1998.  In 2002,real GDP increased 1.1 percent.   But, in the third quarter of 2003, 
growth accelerated to an astounding 8.4 percent; it increased 4.2 percent in the 
fourth quarter of 2003; and it increased 4.2 percent in the fourth quarter of 2006.
So, where are we headed?  Obviously no one really knows.

Even though growth in real GDP has slowed, we have still had advances in our 
standard of living--real GDP per capita.  That's because population grew more 
slowly than real GDP.  From 1990 through 1998, per capita GDP grew at an 
average annual rate of 1.5 percent. 

Sources of economic growth

Economic growth depends on two factors:

Growth rate in real GDP = growth rate of labor force + growth rate of productivity

So what is the growth rate of productivity?  It's the output per labor hour.  The labor 
force has been growing at a long run rate of 1.2 percent per year.  In the period 
from 1990 through 1998, labor productivity grew at 1.1 percent per year.  That gives 
the growth rate of 2.3 percent that we indicated above.  Productivity grew 3.4 percent 
in 2000 and 5.4 percent in 2005.  What gives rise to increased productivity?  One of 
the most important sources is increase in physical capital--more and better capital 
along with technological improvements.  Another factor is human capital--education, 
training and experience--is one important factor.  Other factors include improved 
management (subject to a lot of criticism in the United States) and research and 
development outlays by business firms and government.

The productivity slow down

The main reason why growth in real GDP has slowed down, as we saw above, is because 
of decreases in productivity growth.  That's obvious from the above formula, since the 
growth rate of the labor force is reasonably stable.  In the 1960s, productivity grew at 
an annual rate of 3.3 percent per year.  That fell since the 1960s and for the period 
1990 through 1998, productivity increased only 1.1 percent per year.  Subsequently it 
increased and, as noted above, was about 3 percent in 2006.  Not counting the last 
few years, we ask why productivity declined from the 1960s through 1998.  
There are several reasons.

1.  Lower rate of investment in capital equipment

Firms incurred a lot of government mandated nonproductive expenditure for 
pollution controls and worker safety.  That doesn't mean there is something 
wrong with such expenditure, but it did detract from investment that would 
enhance productivity.  Corporate and individual marginal tax rates were 
high until the reductions in 1980 and 1986.  There was a big problem 
with energy price increases in the 1970s resulting from oil embargos. 
All that partially explains the lower rate of investment in capital.

2.  Capital per worker grew slowly

One reason obviously stems from item 1 above.  Although the long run 
rate of growth in the labor supply appears to have stabilized, there was 
a period where the labor force grew largely as a result of more females 
entering the labor force.

3.  Labor quality

As baby boomers entered the labor force, labor quality suffered a bit.  
The reason?   The baby boomers were not yet experienced, so their 
human capital was not as great as other workers.  That of course 
corrects itself as they gain experience.

4.  A slow down in research and development expenditures

For a time during this period, firms spent less on research and 
development.  The reasons for that are not entirely clear, however.

5.  Management problems

This factor is hard to measure and it isn't clear about how significant 
management problems were.  Many have criticized the management of 
U. S. firms for focusing too much on short term profits and not on 
long term productivity growth, for not being really tuned in to quality, 
for not involving workers in production decisions--and a host of 
other things.

Will the slow down reverse itself?

Certainly the large increases of the last two years are encouraging, but no one 
really knows if that is permanent or not.  Technology is growing exponentially 
and that bodes well for productivity improvement.  Many of the items in the 
above list show signs of becoming reversed.  For now, we simply keep a 
watchful eye on what happens to productivity--and hence to economic growth--
in the coming years.

A comment on government policy

Supply side policies--e.g. lower marginal tax rates and deregulation--do focus 
on growth policies, as well as on stabilization policies.  Monetarists don't think 
that government can do much to enhance growth.  Monetarists are suspicious 
that the large public sector retards development in the private sector.  I think 
it's clear that most contemporary economists don't think government is very 
effective in promoting growth.  Most also agree, however, that government 
could do a lot to reduce growth!

The doomsday prognosticators

There have always been, and still are, those who predict that 

is just around the corner!

Parson Malthus

In 1798, Rev. Malthus--a preacher and sort of an economist--made his historic forecast 
about an economic doomsday.  He insisted that population would grow geometrically--
like 1, 2, 4, 8, 16, etc.  He also insisted that the supply of food would grow only 
arithmetically--like 1, 2, 3, 4, etc.  The result?  Population would outstrip food supply 
and there would be widespread starvation.

(That's a picture of Parson Malthus.  His work is part of the reason
that economics is sometimes called the "dismal science!")

Obviously, Malthus' predictions did not come true.  Why not?  He grossly 
underestimated productivity growth, especially in agriculture.   He also 
overstated population growth.  Clearly there is no scientific basis for 
his geometric and arithmetic forecasts.

Modern doomsday forecasters

Even though Malthus' work was a long time ago, and even though he was wrong, 
there are still lots of contemporary doomsday forecasters.  Consider one example, 
that being a group of MIT "scientists" who predict that growth will halt about 
2050 and then we will have deteriorating living standards.  They predict that 
productivity will fall in half--for no particular reason that I can find.  They, 
like Malthus, are especially pessimistic about agricultural outputs.  They ignore 
signals sent by the price system.  If production slows, prices rise and 
that will restrain consumption and provide an incentive for technological 
advancement.  It's like the example in class when scarce whale oil and rising 
prices of whale oil gave rise to the development of petroleum distillates.  
The scientists also appear to ignore the possibility of developing foods 
other than what we presently consume--perhaps even synthetic ones.

There are other groups who forsee environmental destruction as the basis 
for a doomsday forecast.  Pardon my normative comment, but we have 
already significantly reduced pollution--however clumsily or imperfectly.  
Ten or twenty years ago, a computer would have forecasted for worse 
pollution than we actually have at present.

What about future economic growth?

There are certainly some threats to future economic growth.  Depletion of natural 
resources is one, but many economists think that is not eminent and that the price 
system will be able to deal effectively with resource problems--again the whale oil 
and petroleum example.  Environmental destruction is possible--in spite of 
my comment above.  Overpopulation concerns many, but that appears to be 
more area specific that it is world wide.

Continued economic growth throughout your life time is no doubt possible.  But some 
think that growth is undesirable.  Growth does bring problems, for example:

• Congestion
• Crime
• Under emphasis on values
• Mind boggling problems in poor countries (more on that in part four)
• A life style that is too fast
• And so on . . .

I conclude part three with another normative comment.  Fewer goods and services would 
not, it seems to me, solve any of the above problems.  Continuing to have GDP growth 
which exceeds population growth sounds better to me than the alternative of a reduced 
standard of living.  Do you agree?  It certainly is subject to a lot of debate!

You are now 
three-fourths 
done with Macro!  
Feels good, doesn't it?

To look at the third test from list year, click here:  Part Three Test