Ten Principles of Economics

Chapter 1
Economics by Mankiw
Ten Principles of Economics

⚫ Economy, “oikonomos” (Greek)

– “One who manages a household”
– Households and economies have much in
common
⚫ A household faces many decisions
– Allocate scarce resources
• Taking into account: ability, effort, desire
⚫ Society faces many decisions
– Allocate resources and output
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Scarcity, Goods, and Bads

⚫ A good is called scarce if there is not

enough of it freely available (zero
price) to satisfy human wants.
⚫ An economic good is any good (or
service) that is scarce.
⚫ An economic bad is any good for
which we would pay to have less.

3
Definitions of Economics

⚫ Economics is a way of analyzing and

understanding the ways individuals
and groups of people behave in
terms of their choices regarding the
things they want but can’t get
enough of for free (scarce goods).
⚫ Economics is a social science and a
form of applied logic (reasoning).
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Terms that are often confused:
Scarcity, Shortage, Poverty
⚫ Scarcity means that not enough is
available for free.
⚫ A shortage occurs when not enough is
available at the current price. It is a
problem of price.
⚫ Poverty occurs when the goods are
scarce, and those who need them do not
have the resources to obtain them. It is a
problem of income.
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Scarcity and Choice
⚫ Scarcity necessitates making choices.
⚫ Economics is the study of how people make
choices regarding economic goods.
– As a society:
• Which goods do we create? (Which goods do we allocate our
scarce resources to the production of?)
• How do we produce them at the lowest cost (efficiency)?
• How do we decide who gets the goods once they are produced?
(distribution)
– As individuals:
• Which goods do I purchase?
• In exchange for what?
• How much labor do I sell? (Labor-leisure decision.)

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What Economists Study

⚫ How people make decisions

⚫ How people interact with one another
⚫ Analyze forces and trends that affect
the economy as a whole
– Growth in average income
– Fraction of the population without jobs
– Rate at which prices are rising

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Ten Principles of Economics

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Principle 1:
People face trade-offs
⚫ “There is no such thing as a free
lunch”
– To get something that we like, we
usually have to give up something else
that we also like
⚫ Making decisions
– Trade off one goal against another

9
Efficiency vs. Equality

⚫ Efficiency
– Society getting the maximum benefits
from its scarce resources
– Size of the economic pie
⚫ Equality
– Distributing economic prosperity
uniformly among the members of
society
10
Opportunity Cost
Principle 2: The cost of something is what
you give up to get it
⚫ People face trade-offs
– Make decisions, comparing the cost and
benefits of alternatives (on the margin)
⚫ Opportunity cost
– Whatever must be given up to obtain some
item

11
Opportunity Cost (2)
⚫ Examples
– What does it cost to attend school?
– Society
• National defense vs. consumer goods (guns
vs. butter)
• Capital goods vs. Consumer goods
• Clean environment vs. higher income
• Efficiency vs. equality

12
How People Make Decisions
Principle 3: People are rational, and make
decisions at the margin
⚫ Marginal changes
– Small incremental adjustments: one more or
one less (delta or differential)
⚫ Rational people
– Systematically and purposefully do the best
they can to achieve their objectives
– Make decisions by comparing marginal
benefits and marginal costs (Is MB>MC)
13
Principle 4:
People Respond to Incentives
⚫ Incentives Matter
– Higher price
• Buyers - consume less
• Sellers - produce more
– Public policy
• Change costs or benefits
• Change people’s behavior

14
 Direct and Secondary Effects
⚫ At one time, higher oil prices caused
increased incentives to conserve fuel
– Smaller cars, scooters, bicycles, mass transit
– New, more fuel-efficient aircraft
• Airbus A320 and Boeing 737
– Moved nearer to mass transit stations
– Online courses
– Sean “Diddy” Combs said he started flying on
commercial airlines
– Increased oil exploration
15
 Principle 5:
Trade Can Make People Better Off

⚫ Trade
– Note: You can’t trade what you don’t
own. Property rights are critical.
– Uncoerced trade must create gains.
– Allows each person to specialize in the
activities he or she does best
– Enjoy a greater variety of goods and
services at lower cost
16
Markets
Principle 6: Markets are usually a good
way to organize economic activity
⚫ Communist countries organize their
economies through central planning
– Government officials (central planners)
allocate economy’s scarce resources.

17
Markets (2)
⚫ Market economy, allocation of
resources
– Through decentralized decisions of
many firms and households
– As they interact in markets for goods
and services
– Guided by prices and self-interest

18
Markets (3)

⚫ Adam Smith’s “invisible hand”

– Households and firms interacting in
markets
• Act as if they are guided by an “invisible
hand”
• Leads them to desirable market outcomes
– Corollary: Government intervention
• Prevents the invisible hand’s ability to
coordinate the decisions of the households
and firms that make up the economy
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Which goods do we produce?

⚫ In a market economy, there is

consumer sovereignty. Consumers
determine by their demand (backed
by dollars) what will be produced.
⚫ In a command economy (centrally
planned economy) the government
determines what will be produced.

20
Distribution Decisions
⚫ Because scarce goods are not plentiful
enough to go around, people compete for
them.
⚫ Ownership is allocated via rationing.
⚫ Rationing may take many forms:
– In a centrally planned economy, government
rations the goods.
– In a market economy, ownership of scarce
goods is rationed in markets according to
price.

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Production Decisions
⚫ In a market economy, firms have a profit
incentive to
– respond to consumer demand and
– build products at the lowest possible cost.
⚫ Producing the most output with the least
resources is called efficiency. Firms have
a profit incentive to be efficient.
⚫ In centrally-planned economies, it has
proved difficult to ensure efficiency
without introducing market-type
incentives. 22
Principle 7:
Governments can sometimes improve
market outcomes

⚫ We need government
– Enforce rules and maintain institutions
that are key to a market economy
– Enforce property rights
– Promote efficiency, avoid market failure
– Promote equality, avoid disparities in
economic well-being

23
Why Markets Fail
⚫ Imperfect Property Rights
⚫ Externalities
– Impact of one person’s actions on the well-
being of a bystander
– Pollution
⚫ Market power
– Ability of a single economic actor (or small
group of actors) to have a substantial
influence on market prices

24
Distribution Issues
⚫ Market economy rewards people
according to their ability to produce things
that other people are willing to pay for.
⚫ Government intervention, public policies
may:
– Aim to achieve a more equal distribution of
economic well-being
– Diminish inequality
– But creates other issues.
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The Wealth of Nations
Principle 8: A country’s standard of living
depends on its ability to produce goods and
services
⚫ Large differences in living standards
– Among countries
– Over time
⚫ Average annual income, 2011
– $48,000 (U.S.); $9,000 (Mexico)
– $5,000 (China); $1,200 (Nigeria)
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Wealth of Nations (2)

⚫ Explanation: differences in
productivity
⚫ Productivity
– Quantity of goods and services produced
from each unit of labor input
– Higher productivity
• Higher standard of living
– Growth rate of nation’s productivity
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• Determines growth rate of its average income
 Principle 9:
Prices rise when the government prints too
much money

⚫ Inflation results when too many

dollars chase too few goods and
services
⚫ Inflation
▪ An increase in the overall
level of prices in the economy “Well it may have been 68 cents
when you got in line, but it’s 74
⚫ Causes for large or persistent inflation cents now!”

▪ Growth in quantity of money

– Value of money falls

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There is a short-run trade-off between
inflation and unemployment

Principle 10: Society faces a short-run trade-

off between inflation and unemployment
⚫ Short-run effects of monetary injections:
– Stimulates the overall level of spending
• Higher demand for goods and services
– Firms – raise prices; hire more workers;
produce more goods and services
– Lower unemployment
– Business cycles

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 Chapter 2
⚫ Measuring a Nation’s Income

30
 Economics
⚫ Microeconomics
– Study of how households and firms
• Make decisions
• Interact in markets
⚫ Macroeconomics
– Study of economy-wide phenomena
• Including inflation, unemployment, and economic
growth

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 Economy’s Income & Expenditure

⚫ Gross Domestic Product (GDP)

– Measures the total income of everyone in the
economy
– Measures the total expenditure on the
economy’s output of goods and services
⚫ For an economy as a whole
– Income must equal expenditure

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 Economy’s Income & Expenditure, Part 2

⚫ Circular-flow diagram – assumptions:

– Markets
• Goods and services
• Factors of production
– Households
• Spend all of their income
• Buy all goods and services
– Firms
• Pay wages, rent, profit to resource owners

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Figure 1 The Circular-Flow Diagram

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 The Measurement of GDP
⚫ Gross domestic product (GDP)
– Market value of all final goods and services
– Produced within a country
– In a given period of time
⚫ “GDP is the market value…”
– Market prices – reflect the value of the goods

35
 The Measurement of GDP
⚫ “… of all…”
– All items produced in the economy
• And sold legally in markets
– Excludes most items
• Produced and sold illicitly
• Produced and consumed at home

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 The Measurement of GDP
⚫ “… final…”
– Value of intermediate goods is already
included in the prices of the final goods
⚫ “… goods and services…”
– Tangible goods & intangible services
⚫ “… produced…”
– Goods and services currently produced

37
 The Measurement of GDP
⚫ “… within a country…”
– Goods and services produced domestically
• Regardless of the nationality of the producer
⚫ “… in a given period of time”
– A year or a quarter

38
 The Components of GDP
⚫ Identity: Y = C + I + G + NX
• Y = GDP
• C = consumption
• I = investment
• G = government purchases
• NX = net exports

39
 The Components of GDP
⚫ Consumption, C
– Spending by households on goods and
services
• Goods: durable goods, nondurable goods
• Services: intangibles, spending on education
– Exception: purchases of new housing

40
 The Components of GDP
⚫ Investment, I
– Purchase of (capital) goods that will be used
to produce other goods and services in the
future
• Business capital: business structures,
equipment, and intellectual property products
• Residential capital: landlord’s apartment building;
a homeowner’s personal residence
• Inventory accumulation

41
 The Components of GDP
⚫ Government purchases, G
– Government consumption expenditure and
gross investment
– Spending on goods and services
– By local, state, and federal governments
– Does not include transfer payments

42
 The Components of GDP
⚫ Net exports, NX = Exports - Imports
– Exports
• Spending on domestically produced goods by
foreigners
– Imports
• Spending on foreign goods by domestic residents

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The Components of U.S. GDP
2015, GDP of the U.S.: almost $18 trillion
⚫ GDP per person = $55,822
– Consumption = $38,218 per person
• 68% of GDP
– Investment = $9,402 per person
– Government purchases = $9,919 per person
– Net exports = - $1,657 per person
• Americans spent more on foreign goods than
foreigners spent on American goods

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Table 1 GDP and Its Components

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 Real Versus Nominal GDP
⚫ Total spending rises from one year to the
next
– Economy — producing a larger output of
goods and services
– And/or goods and services are being sold at
higher prices
⚫ Nominal GDP
– Production of goods and services
– Valued at current prices

46
 Real Versus Nominal GDP
⚫ Real GDP
– Production of goods and services
– Valued at constant prices
– Designate one year as base year
– Not affected by changes in prices
⚫ For the base year
– Nominal GDP = Real GDP

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Table 2 Real and Nominal GDP

48
 Real Versus Nominal GDP
⚫ The GDP deflator
– Ratio of nominal GDP to real GDP times 100
– Is 100 for the base year
– Measures the current level of prices relative
to the level of prices in the base year
– Can be used to take inflation out of nominal
GDP (“deflate” nominal GDP)

49
 Real Versus Nominal GDP
⚫ Inflation
– Economy’s overall price level is rising
⚫ Inflation rate
– Percentage change in some measure of the
price level from one period to the next

50
A Half Century of Real GDP
⚫ The GDP data
– Real GDP grows over time
• The real GDP of the U.S. economy in 2015 was
more than four times its 1965 level
• Growth – average 3% per year since 1965
– Growth is not steady
• GDP growth interrupted by recessions

51
A Half Century of Real GDP
⚫ Recession
– Two consecutive quarters of falling GDP
– Real GDP declines
– Lower income
– Rising unemployment
– Falling profits
– Increased bankruptcies

52
Figure 2 Real GDP in the United States

53
 GDP
⚫ GDP – “the single best measure of the
economic well-being of a society”
– Economy’s total income
– Economy’s total expenditure
– Larger GDP
• Good life, better healthcare
• Better educational systems
– Measure our ability to obtain many of the
inputs into a worthwhile life

54
 GDP
⚫ GDP – not a perfect measure of well-
being
– Doesn’t include
• Leisure
• Value of almost all activity that takes place
outside markets
• Quality of the environment
– Nothing about distribution of income

55
International Differences: GDP & Quality of Life

⚫ Rich countries — higher GDP per person

– Better
• Life expectancy
• Literacy
• Internet usage
⚫ Poor countries — lower GDP per person
– Worse
• Life expectancy
• Literacy
• Internet usage

56
International Differences: GDP & Quality of Life

⚫ Low GDP per person

– More infants with low birth weight
– Higher rates of infant mortality
– Higher rates of maternal mortality
– Higher rates of child malnutrition
– Less common access to safe drinking water
– Fewer school-age children are actually in
school

57
International Differences: GDP & Quality of Life

⚫ Low GDP per person

– Fewer teachers per student
– Fewer televisions
– Fewer telephones
– Fewer paved roads
– Fewer households with electricity

58
Table 3 GDP and the Quality of Life

59
 Chapter 2
⚫ Measuring the Cost of Living

60
 The Consumer Price Index
⚫ Consumer price index (CPI)
– Measure of the overall level of prices
– Measure of the overall cost of goods and
services
– Bought by a typical consumer
– Computed and reported every month by the
Bureau of Labor Statistics

61
 Calculating CPI
1. Fix the basket
– Which prices are most important to the
typical consumer
– Different weight
2. Find the prices
– At each point in time
3. Compute the basket’s cost
– Same basket of goods
– Isolate the effects of price changes

62
 Calculating CPI
4. Chose a base year and compute the CPI
– Base year = benchmark
• Price of basket of goods and services in current
year
• Divided by price of basket in base year
• Times 100
5. Compute the inflation rate

63
Table 1 Calculating the Consumer Price Index and
the Inflation Rate: An Example, Part 1

64
Table 1 Calculating the Consumer Price Index and
the Inflation Rate: An Example

65
 The Consumer Price Index
⚫ Inflation rate
– Percentage change in the price index
• From the preceding period
⚫ Core CPI
– Measure of the overall cost of consumer
goods and services excluding food and
energy

66
 The Consumer Price Index
⚫ Producer price index, PPI
– Measure of the cost of a basket of goods and
services bought by firms
– Changes in PPI are often thought to be
useful in predicting changes in CPI

67
Figure 1 The Typical Basket of Goods and
Services

68
 The Consumer Price Index
⚫ Problems in measuring the cost of living
– Substitution bias
• Prices do not change proportionately
• Consumers substitute toward goods that have
become relatively less expensive
– Introduction of new goods
• More variety of goods
– Unmeasured quality change
• Changes in quality

69
 GDP Deflator Versus CPI
⚫ GDP deflator
– Ratio of nominal GDP to
real GDP
– Reflects prices of all goods
& services produced
domestically
⚫ CPI
“The price may seem a
– Reflects prices of goods & little high, but you have
to remember that’s in
services bought by today’s dollars.”
consumers

70
 GDP Deflator Versus CPI
⚫ GDP deflator
– Compares the price of currently produced
goods and services
• To the price of the same goods and services in
the base year
⚫ CPI
– Compares price of a fixed basket of goods
and services
• To the price of the basket in the base year

71
Figure 2 Two Measures of Inflation

72
Regional Differences in the Cost of Living
⚫ The cost of living varies
– Not only over time
– But also over geography
⚫ Regional price parities
– Measure variation in the cost of living from
state to state.

73
Figure 3 Regional Variation in the Cost of
Living

74
 Real and Nominal Interest Rates
⚫ Nominal interest rate
– Interest rate as usually reported
– Without a correction for the effects of
inflation
⚫ Real interest rate
– Interest rate corrected for the effects of
inflation
= Nominal interest rate – Inflation rate

75
Interest Rates in the U.S. Economy
⚫ Nominal interest rate
– Always exceeds the real interest rate
– U.S. economy has experienced rising
consumer prices in every year
⚫ Inflation is variable
– Real and nominal interest rates do not
always move together
⚫ Periods of deflation
– Real interest rate exceeds the nominal
interest rate

76
Figure 4 Real and Nominal Interest Rates

77
 Chapter 3
Production and Growth

1
 ECONOMIC GROWTH
• Economic growth is an increase in the production of
economic goods and services, compared from one period of
time to another. It can be measured in nominal or real
(adjusted for inflation) terms.
Annual economic growth rate:

GDPt − GDPt −1
g=  100%
GDPt −1
 Economic Growth around the World
• Real GDP per person
Living standard
Vary widely from country to country
• Growth rate
How rapidly real GDP per person grew in the typical year
• Because of differences in growth rates
Ranking of countries by income changes substantially
over time
3
Table 1 The Variety of Growth Experiences

4
 Economic growth rate in Vietnam

TUẦN 3 – SẢN XUẤT VÀ TĂNG TRƯỞNG 5

Real GDP per Capita
 QUESTIONS?

• Why are some countries richer than others?

• Why are some countries growing fast while others are
still trapped in poverty?
• What policies can help increase growth and living
standards in the long run?

TUẦN 3 – SẢN XUẤT VÀ TĂNG TRƯỞNG 7

 PRODUCTIVITY

TUẦN 3 – SẢN XUẤT VÀ TĂNG TRƯỞNG 8

 Factors of production

K = capital,
tools, machines, and structures used
in production

L = labor,
the physical and mental efforts of
workers

slide 9
 The production function
• denoted Y = F (K, L)
• shows how much output (Y ) the
economy can produce from
K units of capital and L units of labor.
• reflects the economy’s level of
technology.
• exhibits constant returns to scale.

slide 10
 Returns to scale: a review
Initially Y1 = F (K1 , L1 )
Scale all inputs by the same factor z:
K2 = zK1 and L2 = zL1
(If z = 1.25, then all inputs are increased by 25%)
What happens to output, Y2 = F (K2 , L2 ) ?
• If constant returns to scale, Y2 = zY1
• If increasing returns to scale, Y2 > zY1
• If decreasing returns to scale, Y2 < zY1
slide 11
The Sources of Long-Run Growth

Physical Capital
(Machinery)

Human Capital
(Education)

Technology
(new methods of
production)
 Productivity
• Productivity
Quantity of goods and services
Produced from each unit of labor input
• Why productivity is so important
Key determinants of living standards
Growth in productivity is the key determinant of
growth in living standards
An economy’s income is the economy’s output
13
 Productivity

• Determinants of productivity
✓ Physical capital per worker
✓ Human capital per worker
✓ Natural resources per worker
✓ Technological knowledge

14
 Productivity

• Physical capital
Stock of equipment and structures
Used to produce goods and services
• Human capital
Knowledge and skills that workers acquire
through education, training, and experience

15
 Productivity

• Natural resources
Inputs into the production of goods and services
Provided by nature, such as land, rivers, and
mineral deposits
• Technological knowledge
Society’s understanding of the best ways to
produce goods and services

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 Are Natural Resources a Limit to Growth?

• Argument
World’s population is almost 8 billion
Natural resources — will eventually limit how much the
world’s economies can grow
Fixed supply of nonrenewable natural resources – will
run out
Stop economic growth
Force living standards to fall
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 Are Natural Resources a Limit to Growth?

• Technological progress
• Often yields ways to avoid these limits
✓Improved use of natural resources over time
✓Recycling
✓New materials
• Are these efforts enough to permit continued economic
growth?

18
 Are Natural Resources a Limit to Growth?

• Prices of natural resources

- Scarcity — reflected in market prices
- Natural resource prices
Substantial short-run fluctuations
Stable or falling — over long spans of time
- Our ability to conserve these resources
Growing more rapidly than their supplies are
dwindling
19
 POLICIES

TUẦN 3 – SẢN XUẤT VÀ TĂNG TRƯỞNG 20

 Saving and Investment

• Raise future productivity

→ Invest more current resources in the production of capital
→ Trade-off
+ Devote fewer resources to produce goods and services
for current consumption

21
 Diminishing Returns

• Higher savings rate

- Fewer resources – used to make consumption goods
- More resources – to make capital goods
- Capital stock increases
- Rising productivity
- More rapid growth in GDP

22
 Diminishing Returns
• Diminishing returns
- Benefit from an extra unit of an input
- Declines as the quantity of the input increases
• In the long run, higher savings rate
- Higher level of productivity
- Higher level of income
- Not higher growth in productivity or income

23
Figure 1 Illustrating the Production Function

24
 Diminishing Returns
• Catch-up effect
- Countries that start off poor
- Tend to grow more rapidly than countries that start off
rich
• Poor countries
- Low productivity
- Even small amounts of capital investment
→Increase workers’ productivity substantially
25
 Diminishing Returns

• Rich countries
- High productivity
- Additional capital investment
→ Small effect on productivity
• Poor countries
- Tend to grow faster than rich countries
 Investment from Abroad
• Investment from abroad
- Another way for a country to invest in new capital
- Foreign direct investment
+ Capital investment that is owned and operated by a
foreign entity
- Foreign portfolio investment
+ Investment financed with foreign money but
operated by domestic residents
27
 Investment from Abroad

• Benefits from investment

- Some flow back to the foreign capital owners
- Increase the economy’s stock of capital
- Higher productivity
- Higher wages
- State-of-the-art technologies

28
 Investment from Abroad

• World Bank
- Encourages flow of capital to poor countries
- Funds from world’s advanced countries
- Makes loans to less developed countries
→ Roads, sewer systems, schools, other types of
capital
- Advice about how the funds might best be used

29
 Investment from Abroad

• World Bank and the International Monetary Fund

- Set up after World War II
- Economic distress leads to:
→Political turmoil, international tensions,
and military conflict
- Every country has an interest in promoting
economic prosperity around the world

30
 Education
• Education
- Investment in human capital
- Gap between wages of educated and uneducated workers
- Opportunity cost: wages forgone
- Conveys positive externalities
- Public education – large subsidies to human-capital
investment
• Problem for poor countries: Brain drain
31
 Health and Nutrition
• Human capital
- Education
- Expenditures that lead to a healthier population
• Healthier workers
- More productive
• Wages
- Reflect a worker’s productivity

32
 Health and Nutrition

• Right investments in the health of the population

- Increase productivity
- Raise living standards
• Historical trends: long-run economic growth
- Improved health – from better nutrition
- Taller workers – higher wages – better productivity

33
 Health and Nutrition

• Vicious circle in poor countries

- Poor countries are poor
→Because their populations are not healthy
- Populations are not healthy
→Because they are poor and cannot afford better
healthcare and nutrition

34
 Health and Nutrition

• Virtuous circle
- Policies that lead to more rapid economic growth
- Would naturally improve health outcomes
- Which in turn would further promote economic
growth

35
 Property Rights, Political Stability
• To foster economic growth
- Protect property rights
→Ability of people to exercise authority over the
resources they own
→Courts – enforce property rights
- Promote political stability
• Property rights
- Prerequisite for the price system to work
36
 Property Rights, Political Stability
• Lack of property rights
- Major problem
- Contracts are hard to enforce
- Fraud goes unpunished
- Corruption
→Impedes the coordinating power of markets
→Discourages domestic saving
→Discourages investment from abroad
37
 Property Rights, Political Stability

• Political instability
- A threat to property rights
- Revolutions and coups
- Revolutionary government might confiscate the capital of
some businesses
- Domestic residents – less incentive to save, invest, and
start new businesses
- Foreigners – less incentive to invest
38
 Free Trade

• Inward-oriented policies
- Avoid interaction with the rest of the world
- Infant-industry argument
→Tariffs
→Other trade restrictions
- Adverse effect on economic growth

39
 Free Trade
• Outward-oriented policies
- Integrate into the world economy
- International trade in goods and services
- Economic growth
• Amount of trade – determined by
- Government policy
- Geography
→Easier to trade for countries with natural seaports
40
 Research and Development
• Knowledge – public good
- Government – encourages research and development
• Farming methods
• Aerospace research (Air Force; NASA)
• Research grants
+National Science Foundation
+National Institutes of Health
• Tax breaks
• Patent system
41
 Population Growth
• Large population
- More workers to produce goods and services
→Larger total output of goods and services
- More consumers
• Stretching natural resources
- Malthus: an ever-increasing population
→Strain society’s ability to provide for itself
→Mankind – doomed to forever live in poverty
42
 Population Growth
• Diluting the capital stock
- High population growth
+ Spread the capital stock more thinly
+ Lower productivity per worker
+ Lower GDP per worker
• Reducing the rate of population growth
- Government regulation
- Increased awareness of birth control
- Equal opportunities for women
43
 Population Growth

• Promoting technological progress

- World population growth
→Engine for technological progress and economic
prosperity
→More people = More scientists, more inventors,
more engineers

44
 Chapter 4
Saving, Investment, and the Financial
System

N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or 1
posted to a publicly accessible website, in whole or in part.
 Financial Institutions
• Financial system
– Group of institutions in the economy
• That help match one person’s saving with
another person’s investment
– Moves the economy’s scarce resources
from savers to borrowers
• Financial institutions
– Financial markets
– Financial intermediaries
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 Financial Markets
• Financial markets
– Savers can directly provide funds to
borrowers
– The bond market
– The stock market

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posted to a publicly accessible website, in whole or in part.
 Financial Markets
• The bond market
– Bond: certificate of indebtedness
• Date of maturity, when the loan will be repaid
• Rate of interest, paid periodically until the
date of maturity
• Principal, amount borrowed
– Borrowing from the public
• Used by large corporations, the federal
government, or state and local governments

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posted to a publicly accessible website, in whole or in part.
 Financial Markets
• Bonds differ according to characteristics:
1. Term: length of time until maturity
• A few months, 30 years, perpetuity
• Long-term bonds are riskier than short-term
bonds
• Long-term bonds usually pay higher interest
rates

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posted to a publicly accessible website, in whole or in part.
 Financial Markets
• Bonds differ according to characteristics
2. Credit risk: probability of default
• Probability that the borrower will fail to pay
some of the interest or principal
• Higher interest rates for higher probability of
default
• U.S. government bonds tend to pay low
interest rates
• Junk bonds, very high interest rates: issued
by financially shaky corporations

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posted to a publicly accessible website, in whole or in part.
 Financial Markets
• Bonds differ according to characteristics
3. Tax treatment: interest on most bonds is
taxable income
• Municipal bonds
– Issued by state and local governments
– Owners are not required to pay federal
income tax on the interest income
– Lower interest rate

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posted to a publicly accessible website, in whole or in part.
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or 8
posted to a publicly accessible website, in whole or in part.
 Financial Markets
• The stock market
– Stock: claim to partial ownership in a firm
• A claim to the profits that a firm makes
– Organized stock exchanges
• Stock prices: demand and supply
– Equity finance
• Sale of stock to raise money
– Stock index
• Average of a group of stock prices

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posted to a publicly accessible website, in whole or in part.
 Financial Intermediaries
• Financial intermediaries
– Savers can indirectly provide funds to
borrowers
– Banks
– Mutual funds

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posted to a publicly accessible website, in whole or in part.
 Financial Intermediaries
• Banks
– Take in deposits from savers
• Banks pay interest
– Make loans to borrowers
• Banks charge interest
– Facilitate purchasing of goods and
services
• Checks: medium of exchange

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posted to a publicly accessible website, in whole or in part.
 Financial Intermediaries
• Mutual funds
– Institution that sells shares to the public
– Uses the proceeds to buy a portfolio of
stocks and bonds
– Advantages: diversification; professional
money managers

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posted to a publicly accessible website, in whole or in part.
N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or 13
posted to a publicly accessible website, in whole or in part.
 National Income Accounts
• Rules of national income accounting
– Important identities
• Identity
– An equation that must be true because of
the way the variables in the equation are
defined
– Clarify how different variables are related
to one another

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posted to a publicly accessible website, in whole or in part.
 Accounting Identities
• Gross domestic product (GDP, Y)
– Total income = Total expenditure
• Y = C + I + G + NX
• Y = gross domestic product, GDP
• C = consumption
• I = investment
• G = government purchases
• NX = net exports

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 Accounting Identities
• Closed economy
– Doesn’t interact with other economies
– NX = 0
• Open economy
– Interacts with other economies
– NX ≠ 0

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posted to a publicly accessible website, in whole or in part.
 Accounting Identities
• Assume closed economy: NX = 0
•Y=C+I+G
• National saving (saving), S
• Total income in the economy that remains
after paying for consumption and
government purchases
Y–C–G=I
S=Y–C–G
S=I
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posted to a publicly accessible website, in whole or in part.
 Accounting Identities
• T = taxes minus transfer payments
•S=Y–C–G
• S = (Y – T – C) + (T – G)
• Private saving, Y – T – C
– Income that households have left after
paying for taxes and consumption
• Public saving, T – G
– Tax revenue that the government has left
after paying for its spending
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posted to a publicly accessible website, in whole or in part.
 Accounting Identities
• Budget surplus: T – G > 0
– Excess of tax revenue over government
spending
• Budget deficit: T – G < 0
– Shortfall of tax revenue from government
spending

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posted to a publicly accessible website, in whole or in part.
 Saving and Investing
• Accounting identity: S = I
• Saving = Investment
– For the economy as a whole
– One person’s savings can finance another
person’s investment

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posted to a publicly accessible website, in whole or in part.
 Exercise

• Assume GDP is 10 billion dong,

consumption is 6.5 billion dong,
government spending is 2
billion, and there is a budget
deficit of 300 million dong.
• Calculates public saving, tax,
private saving, national saving,
and investment.

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posted to a publicly accessible website, in whole or in part.
 The Market for Loanable Funds

• Market for loanable funds

– Market
• Those who want to save supply funds
• Those who want to borrow to invest demand
funds
– One interest rate
• Return to saving
• Cost of borrowing
– Assumption: single financial market

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posted to a publicly accessible website, in whole or in part.
 The Market for Loanable Funds

• Supply and demand of loanable funds

– Source of the supply of loanable funds
• Saving
– Source of the demand for loanable funds
• Investment
– Price of a loan = real interest rate
• Borrowers pay for a loan
• Lenders receive on their saving

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posted to a publicly accessible website, in whole or in part.
 Supply of loanable funds

Interest An increase
rate in the interest
Supply rate makes
saving more
6%
attractive,
increasing the
supply of
3%
loanable
funds
60 80 Loanable fund

N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to4 a- TIẾT
CHƯƠNG publicly accessible
KIỆM, ĐẦU TƯ website,
VÀ HỆinTHỐNG
whole or
TÀIin CHÍNH
part.
 Demand of loanable funds

Interest
rate A decrease in the
interest rate reduces
7% the cost of
borrowing, leading
4% to an increase in the
quantity of loanable
Demand funds demanded
50 80 Loanable fund

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posted to4 a- TIẾT
CHƯƠNG publicly accessible
KIỆM, ĐẦU TƯ website,
VÀ HỆinTHỐNG
whole or
TÀIin CHÍNH
part.
 The Market for Loanable Funds

• Supply and demand of loanable funds

– As interest rate rises
• Quantity demanded declines
• Quantity supplied increases
– Demand curve
• Slopes downward
– Supply curve
• Slopes upward

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posted to a publicly accessible website, in whole or in part.
Figure 1 The Market for Loanable Funds

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posted to a publicly accessible website, in whole or in part. 27
 The Market for Loanable Funds
• Government policies
– Can affect the economy’s saving and
investment
• Saving incentives
• Investment incentives
• Government budget deficits and surpluses

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posted to a publicly accessible website, in whole or in part.
 Policy 1: Saving Incentives
• Shelter some saving from taxation
– Affect supply of loanable funds
– Increase in supply
• Supply curve shifts right
– New equilibrium
• Lower interest rate
• Higher quantity of loanable funds
– Greater investment

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posted to a publicly accessible website, in whole or in part.
Figure 2 Saving Incentives Increase the Supply of
Loanable Funds

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posted to a publicly accessible website, in whole or in part. 30
 Policy 2: Investment Incentives
• Investment tax credit
– Affect demand for loanable funds
– Increase in demand
• Demand curve shifts right
– New equilibrium
• Higher interest rate
• Higher quantity of loanable funds
• Greater saving

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posted to a publicly accessible website, in whole or in part.
Figure 3 Investment Incentives Increase the
Demand for Loanable Funds

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posted to a publicly accessible website, in whole or in part. 32
 Policy 3: Budget Deficit/Surplus

• Government – starts with balanced

budget
– Then starts running a budget deficit
• Change in supply of loanable funds
• Decrease in supply
–Supply curve shifts left
• New equilibrium
–Higher interest rate
–Smaller quantity of loanable funds

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posted to a publicly accessible website, in whole or in part.
Figure 4 The Effect of a Government Budget Deficit

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 Policy 3: Budget Deficit/Surplus

• Crowding out
– Decrease in investment
– Results from government borrowing
• Government – budget deficit
– Interest rate rises
– Investment falls

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posted to a publicly accessible website, in whole or in part.
 Policy 3: Budget Deficit/Surplus

• Government – budget surplus

– Increase supply of loanable funds
– Reduce interest rate
– Stimulates investment

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posted to a publicly accessible website, in whole or in part.
 ASK THE EXPERTS
Fiscal Policy and Saving
“Sustained tax and spending policies that boost
consumption in ways that reduce the saving
rate are likely to lower long-run living
standards.”

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posted to a publicly accessible website, in whole or in part. 37
 The History of U.S. Government Debt
• Debt of U.S. federal government
– As a percentage of U.S. GDP
– Fluctuated
• 0% of GDP in 1836
• 107% of GDP in 1945
• Declining debt-to-GDP ratio
– Government indebtedness is shrinking
relative to its ability to raise tax revenue
– Government – living within its means

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posted to a publicly accessible website, in whole or in part. 38
 The History of U.S. Government Debt
• Rising debt-to-GDP
– Government indebtedness is increasing
relative to its ability to raise tax revenue
• Fiscal policy cannot be sustained forever at
current levels
• War – primary cause of fluctuations in
government debt:
– Debt financing of war – appropriate policy
• Tax rates – smooth over time
• Shifts part of the cost to future generations
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posted to a publicly accessible website, in whole or in part. 39
Figure 5 The U.S. Government Debt

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posted to a publicly accessible website, in whole or in part. 40
 The History of U.S. Government Debt
• President Ronald Reagan, 1981
– Large increase in government debt – not
explained by war
– Committed to smaller government and
lower taxes
– Cutting government spending – more
difficult politically than cutting taxes
– Period of large budget deficits
– Government debt: 26% of GDP in 1980 to
50% of GDP in 1993
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 The History of U.S. Government Debt
• President Bill Clinton, 1993
– Major goal – deficit reduction
– And Republicans took control of Congress in
1995: deficit reduction
– Substantially reduced the size of the
government budget deficit
– Booming economy in the late 1990s brought
in even more tax revenue
– Eventually: surplus (federal budget)
– By the late 1990s: debt-to-GDP ratio –
declining for several years
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 The History of U.S. Government Debt
• President George W. Bush
– Debt-to-GDP ratio started rising again
– Budget deficit
• Several major tax cuts
• 2001 recession – decreased tax revenue
and increased government spending
• Increased government spending on
homeland security
–Following the September 11, 2001 attacks
–Subsequent wars in Iraq and Afghanistan

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posted to a publicly accessible website, in whole or in part. 43
 The History of U.S. Government Debt
• 2008, financial crisis and deep recession
– Dramatic increase in the debt-to-GDP
ratio
– Increased budget deficit
– Several policy measures passed by the
Bush and Obama administrations
• Aimed at combating the recession
• Reduced tax revenue
• Increased government spending

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posted to a publicly accessible website, in whole or in part. 44
 The History of U.S. Government Debt
• From 2009 to 2012
– The federal government’s budget deficit
averaged about 9% of GDP
• Levels not seen since World War II
– The borrowing to finance these deficits
• Led to the substantial increase in the debt-to-
GDP ratio (from 39% in 2008 to 70% in 2012)
• After 2012, as the economy recovered
– Budget deficits shrank, and the increases in
the debt-to-GDP ratio became smaller
– Pres. Trump's tax cut in 2018
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posted to a publicly accessible website, in whole or in part. 45
 Chapter 5

Unemployment

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posted to a publicly accessible website, in whole or in part.
 Identifying Unemployment
• Employed
– Those who worked
• Paid employees
• In their own business
• Unpaid workers in a family member’s
business
–Full-time and part-time workers
–Temporarily absent
• Vacation, illness, bad weather

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 Identifying Unemployment
• Unemployed
– Those who were not employed
• Available for work
• Tried to find employment during the previous
four weeks
– Those waiting to be recalled to a job
• Laid off

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 Identifying Unemployment
• Not in the labor force
– Not employed and not unemployed
– Full-time students
– Homemakers
– Retirees

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Figure 1 The Breakdown of the Population in
January 2019

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posted to a publicly accessible website, in whole or in part. 5
 Identifying Unemployment

• Labor force
• Total number of workers, employed and
unemployed
= Number of employed + Number of unemployed
• Unemployment rate
– Percentage of labor force that is unemployed

Number of unemployed
Unemployment rate = ×100
Labor force

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 Identifying Unemployment
• Labor-force participation rate
– Percentage of the total adult population that
is in the labor force
– Fraction of the population that has chosen
to participate in the labor market

Labor force
Labor−force participation rate = ×100
Adult population

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Figure 2 Unemployment Rate Since 1960

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posted to a publicly accessible website, in whole or in part. 8
 Identifying Unemployment
• Natural rate of unemployment
– Normal rate of unemployment around
which the unemployment rate fluctuates
– 4.6% in 2018 (close to the actual
unemployment rate of 3.9%)
• Cyclical unemployment
– Deviation of unemployment from its
natural rate

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posted to a publicly accessible website, in whole or in part.
 Identifying Unemployment
• Official unemployment rate
– Useful
– Imperfect measure of joblessness
• Movements into and out of the labor force
– Common
– More than one-third of unemployed
• Recent entrants into the labor force

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posted to a publicly accessible website, in whole or in part.
 Identifying Unemployment
• Unemployment
– Not all unemployment ends with the job
seeker finding a job
• Half of all spells of unemployment end when
the unemployed leaves the labor force
• Some of those who report being unemployed
– May not be trying hard to find a job
• Want to qualify for a government help
• Working but paid “under the table”

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posted to a publicly accessible website, in whole or in part.
 Identifying Unemployment
• Some of those who are out of labor force
– May want to work: discouraged workers
• Discouraged workers
– Individuals who would like to work
– Have given up looking for a job

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posted to a publicly accessible website, in whole or in part.
 Identifying Unemployment
• Unemployment rate
– Never falls to zero
– Fluctuates around the natural rate of
unemployment
• Frictional unemployment
– It takes time for workers to search for the
jobs that best suit their tastes and skills
– Explain relatively short spells of
unemployment
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posted to a publicly accessible website, in whole or in part.
 Identifying Unemployment
• Structural unemployment
– Results because the number of jobs
available in some labor markets
• Is insufficient to provide a job for everyone
who wants one
– Explains longer spells of unemployment
– Results when wages are set above the
equilibrium
• Minimum-wage laws, unions, and efficiency
wages
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posted to a publicly accessible website, in whole or in part.
 Job Search
• Job search
– Process by which workers find appropriate
jobs given their tastes and skills
• Workers differ in their tastes and skills
• Jobs differ in their attributes
• Information about job candidates and job
vacancies is disseminated slowly

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posted to a publicly accessible website, in whole or in part.
 Job Search
• Some frictional unemployment is
inevitable
– Changes in demand for labor among
different firms
– Changes in composition of demand
among industries or regions (sectoral
shifts)
– Changing patterns of international trade
• Workers need to move among industries

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posted to a publicly accessible website, in whole or in part.
 Job Search
• Some frictional unemployment is
inevitable
– The economy is always changing
– From 2004 to 2014, employment
• Fell by 838,000 in construction and 2.1 million
in manufacturing
• Rose by 321,000 in mining, 629,000 in
computer systems design, 1.9 million in food
services, and 2.6 million in health care

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posted to a publicly accessible website, in whole or in part.
 Public Policy and Job Search
• Reduce time for unemployed to find jobs
– Reduce natural rate of unemployment
• Government programs – to facilitate job
search
– Government-run employment agencies
– Public training programs

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posted to a publicly accessible website, in whole or in part.
 Public Policy and Job Search
• Unemployment insurance
– Government program
– Partially protects workers’ incomes
• When they become unemployed
– Increases frictional unemployment
• Without intending to do so
– Qualify – only the unemployed who were
laid off because their previous employers
no longer needed their skills
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posted to a publicly accessible website, in whole or in part.
 Public Policy and Job Search
• Unemployment insurance
– 50% of former wages for 26 weeks
– Reduces the hardship of unemployment
– Increases the amount of unemployment
• Unemployment benefits stop when a worker
takes a new job
• Unemployed
– Devote less effort to job search
– More likely to turn down unattractive job offers
– Less likely to seek guarantees of job security
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posted to a publicly accessible website, in whole or in part.
 Minimum-Wage Laws
• Structural unemployment
– Number of jobs – insufficient
• Minimum-wage laws
– Can cause unemployment
– Forces the wage to remain above the
equilibrium level
• Higher quantity of labor supplied
• Smaller quantity of labor demanded
• Surplus of labor = unemployment

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posted to a publicly accessible website, in whole or in part.
Figure 4 Unemployment from a Wage above the
Equilibrium Level

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posted to a publicly accessible website, in whole or in part. 22
 Minimum-Wage Laws
• Wages may be kept above equilibrium
level
– Minimum-wage laws
– Unions
– Efficiency wages
• If the wage is kept above the equilibrium
level
– Result: unemployment

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posted to a publicly accessible website, in whole or in part.
 Unions & Collective Bargaining

• Union
– Worker association
– Bargains with employers over
• Wages, benefits, and working conditions
– Less than 11% of U.S. workers today
• About 33% in the 1940s and 1950s
– Type of cartel

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posted to a publicly accessible website, in whole or in part.
 Unions & Collective Bargaining

• Collective bargaining
– Process by which unions and firms agree on
the terms of employment
• Strike
– Organized withdrawal of labor from a firm by
a union
– Reduces production, sales, and profit
• Union workers
– Earn 10-20% more than similar workers who
do not belong to unions
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posted to a publicly accessible website, in whole or in part.
 Unions & Collective Bargaining, Part 3

• Union – raises the wage above the

equilibrium level
– Higher quantity of labor supplied
– Smaller quantity of labor demanded
– Unemployment
– Better off: employed workers (insiders)
– Worse off: unemployed (outsiders)
• May stay unemployed
• Take jobs in firms that are not unionized
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posted to a publicly accessible website, in whole or in part.
 Unions & Collective Bargaining
• Union – raises wage above
equilibrium
– Supply of labor in industries
not unionized will increase,
lower wages
• Workers in unions
– Reap the benefit of “Gentlemen, nothing
stands in the way of a
collective bargaining final accord except that
management wants
• Workers not in unions profit maximization and
– Bear some of the cost the union wants more
moola.”

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posted to a publicly accessible website, in whole or in part.
 Unions & Collective Bargaining

• Are unions good or bad for the economy?

– Critics
• Unions – a type of cartel
• Allocation of labor
–Inefficient – high union wages reduce
employment in unionized firms below
the efficient level
–Inequitable – some workers benefit at
the expense of other workers

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posted to a publicly accessible website, in whole or in part.
 Unions & Collective Bargaining

• Are unions good or bad for the economy?

– Advocates
• Unions – necessary antidote to the market
power of the firms that hire workers
–In the absence of a union, firms pay
lower wages and offer worse working
conditions
• Unions – help firms respond efficiently to
workers’ concerns
–Keep a happy and productive workforce
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posted to a publicly accessible website, in whole or in part.
 Theory of Efficiency Wages
• Efficiency wages
– Above-equilibrium wages paid by firms to
increase worker productivity
• Worker health; Worker turnover
• Worker quality; Worker effort

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 Theory of Efficiency Wages
• Worker health
– Better paid workers
• Eat a more nutritious diet
• Healthier and more productive
• Worker turnover
– Firm – can reduce turnover among its
workers
• By paying them a high wage

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posted to a publicly accessible website, in whole or in part.
 Theory of Efficiency Wages
• Worker quality
– Firm – pays a high wage
• Attracts a better pool of workers
• Increases the quality of its workforce
• Worker effort
– High wages – make workers more eager
to keep their jobs
• Give workers an incentive to put forward their
best effort

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posted to a publicly accessible website, in whole or in part.
 Chapter 6

The Monetary System

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posted to a publicly accessible website, in whole or in part.
 The Meaning of Money
• Barter
– Exchanging one good or service for
another
– Trade requires double coincidence of
wants
• Unlikely occurrence that two people each
have a good or service that the other wants
• Money
– Makes trade easier
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posted to a publicly accessible website, in whole or in part.
 The Meaning of Money
• Money
– Set of assets in an economy
– That people regularly use
– To buy goods and services from other
people
• Liquidity
– Ease with which an asset can be
converted into the economy’s medium of
exchange
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posted to a publicly accessible website, in whole or in part.
 The Functions of Money
1. Medium of exchange
– Item that buyers give to sellers when they
want to purchase goods and services
2. Unit of account
– Yardstick people use to post prices and
record debts
3. Store of value
– Item that people can use to transfer
purchasing power from the present to the
future
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posted to a publicly accessible website, in whole or in part.
 The Kinds of Money
• Commodity money
– Money that takes the form of a commodity
with intrinsic value: gold, cigarettes
• Intrinsic value
– Item would have value even if it were not
used as money
• Gold standard - Gold as money
– Or paper money that is convertible into
gold on demand
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posted to a publicly accessible website, in whole or in part.
 The Kinds of Money
• Fiat money
– Money without intrinsic value
– Used as money because of government
decree
– “This note is legal tender for all debts,
public and private”
• Fiat
– Order or decree

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 Money in the U.S. Economy
• Money stock
– Quantity of money circulating in the
economy
• Currency
– Paper bills and coins in the hands of the
public
• Demand deposits
– Balances in bank accounts; depositors
can access on demand by writing a check
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 Money in the U.S. Economy
• Measures of money stock
– M1
• Demand deposits, Traveler’s checks
• Other checkable deposits, Currency
– M2
• Everything in M1
• Savings deposits, Small time deposits
• Money market mutual funds
• A few minor categories

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Figure 1 Two Measures of the Money Stock for the
U.S. Economy

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 The Federal Reserve System
• Central bank
– Institution designed to
• Oversee the banking system
• Regulate the quantity of money in the economy
• The Federal Reserve (the Fed)
– The central bank of the United States
– Created in 1913 after a series of bank failures
in 1907
– Purpose: to ensure the health of the nation’s
banking system
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 Banks and the Money Supply
• Money
– Currency + Demand deposits
• Behavior of banks
– Can influence the quantity of demand
deposits in the economy (and the money
supply)

“I’ve heard a lot about

money, and now I’d like
to try some.”

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posted to a publicly accessible website, in whole or in part.
 Banks and the Money Supply

• Reserves
– Deposits that banks have received but
have not loaned out
• The simple case of 100% reserve banking
– All deposits are held as reserves
• Banks do not influence the supply of money

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 Fractional-Reserve Banking
• Fractional-reserve banking
– Banks hold only a fraction of deposits as
reserves
• Reserve ratio
– Fraction of deposits that banks hold as
reserves
• Reserve requirement
– Minimum amount of reserves that banks
must hold; set by the Fed
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posted to a publicly accessible website, in whole or in part.
 Fractional-Reserve Banking

• Excess reserve
– Banks may hold reserves above the legal
minimum
• Example: First National Bank
– Reserve ratio 10%

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posted to a publicly accessible website, in whole or in part.
 Fractional-Reserve Banking
• Banks hold only a fraction of deposits in
reserve
– Banks create money
• Assets
• Liabilities
– Increase in money supply
– Does not create wealth

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posted to a publicly accessible website, in whole or in part.
 The Money Multiplier

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 The Money Multiplier
• The money multiplier
– Original deposit = $100.00
– First National lending = $ 90.00 [= .9 × $100.00]
– Second National lending=$ 81.00 [= .9 × $90.00]
– Third National lending = $ 72.90 [= .9 × $81.00]
–…
– Total money supply = $1,000.00

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posted to a publicly accessible website, in whole or in part.
 The Money Multiplier
• The money multiplier
– Amount of money the banking system
generates with each dollar of reserves
– Reciprocal of the reserve ratio = 1/R
• The higher the reserve ratio
– The smaller the money multiplier

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posted to a publicly accessible website, in whole or in part.
 Fed’s Tools of Monetary Control

• Influences the quantity of reserves

– Open-market operations
– Fed lending to banks
• Influences the reserve ratio
– Reserve requirements
– Paying interest on reserves

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posted to a publicly accessible website, in whole or in part.
 Fed’s Tools of Monetary Control, Part 2

• Open-market operations
– Purchase and sale of U.S. government
bonds by the Fed
– To increase the money supply
• The Fed buys U.S. government bonds
– To reduce the money supply
• The Fed sells U.S. government bonds
– Easy to conduct
– Used more often
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posted to a publicly accessible website, in whole or in part.
 Fed’s Tools of Monetary Control

• Fed lending to banks

• To increase the money supply
• Discount window
• At the discount rate
– Term Auction Facility
• To the highest bidder

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posted to a publicly accessible website, in whole or in part.
 Fed’s Tools of Monetary Control

• The discount rate

– Interest rate on the loans that the Fed
makes to banks
– Higher discount rate
• Reduce the money supply
– Smaller discount rate
• Increase the money supply

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posted to a publicly accessible website, in whole or in part.
 Fed’s Tools of Monetary Control

• Term Auction Facility (2007 to 2010)

– The Fed sets a quantity of funds it wants
to lend to banks
– Eligible banks bid to borrow those funds
– Loans go to the highest eligible bidders
• Acceptable collateral
• Pay the highest interest rate

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posted to a publicly accessible website, in whole or in part.
 Fed’s Tools of Monetary Control

• Reserve requirements
– Minimum amount of reserves that banks
must hold against deposits
• An increase in reserve requirement: decrease
the money supply
• A decrease in reserve requirement: increase
the money supply
– Used rarely – disrupt business of banking
– Less effective in recent years
• Many banks hold excess reserves
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posted to a publicly accessible website, in whole or in part.
 Fed’s Tools of Monetary Control

• Paying interest on reserves

– Since October 2008
– The higher the interest rate on reserves
• The more reserves banks will choose to hold
– An increase in the interest rate on
reserves
• Increase the reserve ratio
• Lower the money multiplier
• Lower the money supply

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posted to a publicly accessible website, in whole or in part.
 Problems
• The Fed’s control of the money supply
– Not precise
• The Fed does not control:
– The amount of money that households
choose to hold as deposits in banks
– The amount that bankers choose to lend

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posted to a publicly accessible website, in whole or in part.
 Bank Runs and the Money Supply

• Bank runs
– Depositors fear that a bank may be
having financial troubles
• “Run” to the bank to withdraw their deposits
– Problem for banks under fractional-
reserve banking
• Cannot satisfy withdrawal requests from all
depositors

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posted to a publicly accessible website, in whole or in part. 27
 Bank Runs and the Money Supply

• When a bank run occurs

– The bank - is forced to close its doors
– Until some bank loans are repaid
– Or until some lender of last resort
provides it with the currency it needs to
satisfy depositors
– Complicate the control of the money
supply

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posted to a publicly accessible website, in whole or in part. 28
 Bank Runs and the Money Supply

• Great Depression, early 1930s

– Wave of bank runs and bank closings
– Households and bankers - more cautious
– Households
• Withdrew their deposits from banks

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posted to a publicly accessible website, in whole or in part. 29
 Bank Runs and the Money Supply

• Great Depression, early 1930s

– Bankers - responded to falling reserves
• Reducing bank loans,
• Increased their reserve ratios
• Smaller money multiplier
• Decrease in money supply

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posted to a publicly accessible website, in whole or in part. 30
 Bank Runs and the Money Supply

• No bank runs today

– Depositors are confident
– FDIC will make good on the deposits
• Government deposit insurance
– Guarantees the safety of deposits at most
banks: Federal Deposit Insurance
Corporation (FDIC)
– Cost: Bankers - little incentive to avoid bad
risks
– Benefit: A more stable banking system
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 The Federal Funds Rate
• The federal funds rate
– Interest rate at which banks make
overnight loans to one another
• Lender – has excess reserves
• Borrower – needs reserves
– A change in federal funds rate
• Changes other interest rates

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posted to a publicly accessible website, in whole or in part.
 The Federal Funds Rate
• The federal funds rate
– Differs from the discount rate
– Affects other interest rates as well
– Is determined by supply and demand in
the market for loans among banks
– Targeted by the Fed
• Change the federal funds rate
• Change the money supply

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posted to a publicly accessible website, in whole or in part.
 The Federal Funds Rate
• The Fed targets the federal funds rate
through open-market operations
– The Fed buys bonds
• Decrease in the federal funds rate
• Increase in money supply
– The Fed sells bonds
• Increase in the federal funds rate
• Decrease in money supply

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posted to a publicly accessible website, in whole or in part.