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The Federal Reserve System We have seen how the private banking system creates money by making loans. However, private banks are not free to create money at will. Their ability to create money is controlled by the volume of reserves in the system , which is controlled by the Central Bank(Fed). The Fed therefore has the ultimate control over the money supply. We will now examine the structure and function of the Fed.   The United States is divided into 12 Federal Reserve districts, each with its own Federal Reserve bank. These districts are indicated on the map in Figure. The district banks are like branch offices of the Fed in that they carry out the rules, regulations, and functions of the central system.  Federal Open Market Committee (FOMC)  is a group composed of the seven members of the Fed’s Board of Governors, the president of the New York Federal Reserve Bank, and four of the other 11 district bank presidents on a rotating basis; it sets goals concerning the mon...

The economy affects the federal government budget even if there are no explicit fiscal policy changes. There are effects that the government has no direct control over. They can be lumped under the general heading of “automatic stabilizers and destabilizers.” Automatic Stabilizers and Destabilizers Most of the tax revenues of the government result from applying a tax rate decided by the government to a base that reflects the underlying activity of the economy. The corporate profits tax, for example, comes from applying a rate (say 35 percent) to the profits earned by firms. Income taxes come from applying rates shown in tax tables to income earned by individuals. Tax revenues thus depend on the state of the economy even when the government does not change tax rates. When the economy goes into a recession, tax revenues will fall, even if rates remain constant, and when the economy picks up, so will tax revenues. As a result, deficits fall in expansions and rise in recessions, other thi...

Almost all financial markets clear—that is, almost all reach an equilibrium where quantity demanded equals quantity supplied. In the money market, the point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy. This explanation sounds simple, but it requires elaboration. Supply and Demand in the Money Market The  Fed or Central Bank controls the money supply through its manipulation of the amount of reserves in the economy. Because we are assuming that the Fed’s money supply behavior does not depend on the interest rate, the money supply curve is a vertical line. In other words, we are assuming that the Fed uses its three tools (the required reserve ratio, the discount rate, and open market operations ) to achieve its fixed target for the money supply. Adjustments in the Money Market-  Equilibrium exists in the money market when the supply of money is equal to the demand for money and thus when ...

Interest Rates and Bond Prices  Interest Rates and Bond Prices Interest is the fee that borrowers pay to lenders for the use of their funds. . Firms and governments borrow funds by issuing bonds, and they pay interest to the lenders that purchase the bonds. Households also borrow, either directly from banks and finance companies or by taking out mortgages.  Some loans are very simple. You might borrow $1,000 from a bank to be paid back a year from the date you borrowed the funds. If the bank charged you, say, $100 for doing this, the interest rate on the loan would be 10 percent. You would receive $1,000 now and pay back $1,100 at the end of the year—the original $1,000 plus the interest of $100. In this simple case the interest rate is just the interest payment divided by the amount of the loan, namely 10 percent.  Bonds are more complicated loans. Bonds have several properties. First, they are issued with a face value, typically in denominations of $1,000. Second,...

Keynesian Economics  John Maynard Keynes’s General Theory of Employment, Interest, and Money, published in 1936, remains one of the most important works in economics. Keynes was the first to emphasize aggregate demand and links between the money market and the goods market. Keynes also emphasized the possible problem of sticky wages. In recent years, the term Keynesian has been used more narrowly. Keynes believed in an activist federal government. He believed that the government had a role to play in fighting inflation and unemployment, and he believed that monetary and fiscal policy should be used to manage the macroeconomy. This is why Keynesian is sometimes used to refer to economists who advocate active government intervention in the macroeconomy. Monetarism  The debate between monetarist and Keynesian economics is complicated because it means different things to different people. If we consider the main monetarist message to be that “money matters,” then almost ...

  Money Supply and The Federal Reserve System Here comes the first question,  What is Money?  Well, money is—a means of payment, a store of value, and a unit of account. A Means of Payment, or Medium of Exchange Money is vital to the working of a market economy. The alternative to a monetary economy is  barter , people exchanging goods and services for other goods and services directly instead of exchanging via the medium of money. How does a barter system work? Suppose you want bread, and orange juice for breakfast. Instead of going to the store and buying these things with money, you would have to find someone who has the items and is willing to trade them. You would also have to have something the orange juice purveyor, and the bread vendor want. Having pencils to trade will do you no good if the orange juice, and bread sellers do not want pencils. A barter system requires a double coincidence of wants for trade to take place. That is, to effect a trade, you have ...

 Continued... The Tax Multiplier The Government Spending Multiplier :  Increasing government spending by 50 shifts the AE function up by 50. As Y rises in response, additional consumption is generated. Overall, the equilibrium level of Y increases by 200, from 900 to 1,100. Instead of increasing government spending (G), cut taxes and maintain the current level of spending. A tax cut increases disposable income, which is likely to lead to added consumption spending.A decrease in taxes would increase income. The government spends no less than it did before the tax cut, and households find that they have a larger after-tax (or disposable) income than they had before. This leads to an increase in consumption. Planned aggregate expenditure will increase, which will lead to inventories being lower than planned, which will lead to a rise in output. When output rises, more workers will be employed and more income will be generated, causing a second-round increase in consumption, and ...

The Determination of Equilibrium Output (Income)  Equilibrium occurs where Y = AE—that is, where aggregate output equals planned aggregate expenditure. Remember that planned aggregate expenditure in an economy with a government is AE C + I + G, so equilibrium is Y = C + I + G If output (Y) exceeds planned aggregate expenditure (C + I + G), there will be an unplanned increase in inventories—actual investment will exceed planned investment. Conversely, if C + I + G exceeds Y, there will be an unplanned decrease in inventories.  First, our consumption function, C = 100 + .75Y before we introduced the government sector, now becomes Second, we assumed that the government is running a balanced budget, financing all of its spending with taxes. So, G=100 ,T=100 and planned investment (I) is 100. Table calculates planned aggregate expenditure at several levels of disposable income. For example, at Y = 500, disposable income is Y - T= 400. Therefore, C = 100 + .75(400) = 400. Assuming t...

Fiscal policy   It refers to the government’s spending and taxing behavior—in other words, its budget policy. (The word fiscal comes from the root fisc, which refers to the “treasury” of a government.) Fiscal policy is generally divided into three categories:  (1) policies concerning government purchases of goods and services (2) policies concerning taxes (3) policies concerning transfer payments (such as unemployment compensation, Social Security benefits, welfare payments, and veterans’ benefits) to households.  Monetary policy  refers to the behavior of the nation’s central bank, the Federal Reserve, concerning the nation’s money supply. Government in the Economy discretionary fiscal policy- Changes in taxes or spending that are the result of deliberate changes in government policy. Government Purchases (G), Net Taxes (T), and Disposable Income (Yd) –  Net taxes (T )  Taxes paid by firms and households to the government minus transfer payments made to ho...