Apr 09 2008

From the Help Desk – crowding out, money market and new money creation

“Dan” submits the following questions to the AP/IB Economics Help Desk:

Hello Jason, I’m a first year Macro AP Econ Teacher, but a long time social studies and JA Economics Teacher. My Questions:

1. I’m confused about Crowding Out. I thought it meant that when the government ran a budget deficit. It causes the government to compete for loanable money so that they can finance the deficit. Thus competing for loanable funds in the “money market”? Causing interest rates to rise because of increased demand. Moving private investment money to government bonds etc, because of the higher interest? Am I way off?

My reply: There are actually two markets for money. In the one the AP refers to as the “money market”, supply of money is perfectly inelastic, in other words it does not change with the interest rate, rather the interest rate is determined by the supply curve’s movements in or out. Supply in the “money market” is determined by the central bank which manipulates the amount of money in circulation through open market operations, changing the discount rate and the reserve ratio. Demand in the money market is the sum of the public’s demand for money as an asset and for transactions. Primarily, as national income grows, money demand grows. We say that the “money market” shows the nominal interest rate, since it’s determined by the Fed’s monetary policies.

The other market for money is the “loanable funds market”. This market refers to the money that banks and other lending institutions make available to households, firms and the government to borrow. When the government deficit spends, it does so by issuing new debt securities. Increasing the supply of government bonds lowers their price making them attractive to investors, who take their money out of banks to buy bonds. Both the money supply and the supply of loanable funds shift leftward, driving up nominal and real interest rates (of course, that depends on the rate of inflation). Another way to think of this is the demand for loanable funds shifts out as the government deficit spends; either way (leftward shift of supply or rightward shift of demand), the real interest rate will increase.

Crowding-out occurs because of the inverse relationship between real interest rate and the demand for investment funds. Private investors face higher real interest rates when the government finances its spending by selling bonds to the public (in other words, borrowing from the public).
To see the graphs for the money market and the loanable funds market, read my recent blog post, “Loanable Funds vs. the Money Market: what’s the difference?”

Dan: Other questions, when does “saving” become “investment”

Example: If I buy McDonalds stock in the primary market is that “saving” in the sense that McDonalds uses my money to then “invest” in expanding their market share with New Restaurants in market’s around the world. Or is my purchase of the stock investment? Am I right that individuals contribute to the Saving Supply by putting deposits in banks which then becomes loanable money?

My reply: The purchase of stocks is not considered an investment, because it does not get included in the nation’s GDP. Stock purchases are purely financial transactions; you’re making capital available to the firm for investment. I’m not exactly sure what the buying of stocks would be called from an accounting standpoint, but it is a “non-production transaction”, so does not contribute to national income.

You’re correct that when you increase your savings in financial institutions, you are contributing to the supply of loanable funds. In fact, anything that increases national savings rates will shift the supply of loanable funds outward, lowering the real interest rate and encouraging new investment. So in that regard, savings leads to investment, yes.

Dan: One more about money creation. If I put 1,000 dollars in the bank and reserve ratio is 25%. Is with no drainage, can you say that 4,000 dollars are “created” and does the 4,000 include the original 1,000? Thus really only 3,000 is created?

My reply: I teach my students that the initial deposit of $1,000 does not count as “new money” since it was already part of the money supply. Therefore, a bank that prefers to loan out all its excess reserves would keep $250 of your $1,000 on reserve, loan out $750, and by determining the money multiplier (1/RR, or 4 in this case), we can determine how much new money is created from your initial deposit. Multiply the new excess reserves by the multiplier, and you’ll see that $750 x 4 = $3000 of new money created after an initial change in checkable deposits of $1000.

Now, if the new money had come not from YOU or ME, but from the FED (from the purchase of bonds from the bank), then the $1000 WOULD be counted as new money, since it was not in the money supply while held by the Fed. In that case, new money creation would be $1000 x 4 = $4000. But money already in circulation is deposited, only the new excess reserves count towards new money creation.

Great questions, Dan. I hope my answers are helpful… by no means do I claim that they’re necessarily right, they’re just my interpretation and what I’m teaching my students here at SAS!


About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author


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