Update: Once again I have updated this post with a few minor changes. Notably, I have added to graphs illustrating a separate shift in supply and demand for loanable funds. Based on discussions with readers via email, it appears that my previous graph illustrating in one diagram the shifts of both supply and demand was confusing and could be considered double counting the effect of an increase in deficit spending. Thanks again to Professor Chuck Orvis for his valuable input.

*Click on a graph to see the full-sized version

Two markets for money, right? Yes… so do they show the same thing? NO! You must know the distinction between these two markets. First let’s talk about the Money Market diagram.

This market refers to the Money Supply (M1 and M2). The Money Supply curve is vertical because it is determined by the Fed’s (or central bank’s) particular monetary policy. On the X axis is the Quantity of money supplied and demanded, and on the Y axis is the nominal interest rate. A tight monetary policy (selling of bonds by the Fed) will shift Money Supply in, raising the federal funds rate, and subsequently the interest rates commercial banks charge their best customers (prime interest rate). On the other hand, an easy money policy (buying of bonds by the Fed) shifts Sm out, lowering the Federal Funds rate and thus the prime interest rate.

You should also know why a tight money policy is considered contractionary and why an easy money policy is considered expansionary monetary policy. Higher nominal interest rates resulting from tight money policy will discourage investment and consumption, contracting aggregate demand. On the other hand, an easy money policy will encourage more investment and consumption as nominal rates fall, expanding aggregate demand.

Government deficit spending and the money market: Does an increase in government spending without a corresponding increase in taxes affect the money market? You may be inclined to say yes, since the Treasury must issue new bonds to finance deficit spending. After all, when the Fed sells bonds, money is taken out of circulation and held by the Fed, thus it’s no longer part of the money supply.

When the Treasury issues and sells new bonds, however, the money the public uses to buy the bonds is put back into circulation as the government spending is increased. Therefore, any leftward shift of the money supply curve caused by the buying of bonds by the public is offset by the injection of cash in the economy initiated the government’s fiscal stimulus package takes effect (be it a tax rebate or an increase in spending). Therefore, money supply should remain stable when the government deficit spends.

Now to the loanable funds market. Loanable funds represents the money in commercial banks and lending institutions that is available to lend out to firms and households to finance expenditures (investment or consumption). The Y-axis represents the real interest rate; the loanable funds market therefore recognizes the relationships between real returns on savings and real price of borrowing with the public’s willingness to save and borrow.

Since an increase in the real interest rate makes households and firms want to place more money in the bank (and more money in the bank means more money to loan out), there is a direct relationship between real interest rate and Supply of Loanable Funds. On the other hand, since at lower real interest rates households and firms will be less inclined to save and more inclined to borrow and spend, the Demand for loanable funds reflects an inverse relationship. At higher interest rates, households prefer to delay their spending and put their money in savings, since the opportunity cost of spending now rises with the real interest rate.

Government deficit spending and the loanable funds market: We learned above that only the Fed can shift the money supply curve, but what factors can affect the Supply and Demand curves for loanable funds? Here’s a few key points to know about the loanable funds market.

• When the government deficit spends (G>tax revenue), it must borrow from the public by issuing bonds.
• The Treasury issues new bonds, which shifts the supply of bonds out, lowering their prices and raising the interest rates on bonds.
• In response to higher interest rates on bonds, investors will transfer their money out of banks and other lending institutions and into the bond market. Banks will also lend out fewer of their excess reserves, and put some of those reserves into the bond market as well, where it is secure and now earns relatively higher interest.
• As households, firms and banks buy the newly issued Treasury securities (which represents the public’s lending to the government), the supply of private funds available for lending to households and firms shifts in. With fewer funds for private lending banks must raise their interest rates, leading to a movement along the demand curve for loanable funds.
• This causes crowding out of private investment.

Another, simpler way to understand the effect of government deficit spending on real interest rates is to look at it from the demand side.

• Deficit spending by the government requires the government to borrow from the public, increasing the demand for loanable funds. In essence, the government becomes a borrower in the country’s financial sector, demanding new funds for investment, driving up real interest rates.
• Increased demand from the government pushes interest rates up, causing banks to supply a greater quanity of funds for lending. The private, however, now has fewer funds available to borrow as the government soaks up some of the funds that previously would have gone to private borrowers.
• This leads to the crowding out of private investment, in which private borrowers face higher real interest rates due to increased deficit spending by the government.

What could shift the supply of loanable funds to the right? Easy, anything that increases savings by households and firms, known as the determinants of consumption and saving. These include increases in wealth, expectations of future income and price levels, and lower taxes. If savings increases, supply of loanable funds shifts outward, increasing the reserves in banks, lowering real interest rates, encouraging firms to undertake new investments. This is why many economists say that “savings is investment”. What they mean is increased increased savings leads to an increase in the supply of loanable funds, which leads to lower interest rates and increased investment.

On the other hand, an increase in demand for investment funds by firms will shift demand for loanable funds out, driving up real interest rates. The determinants of investment include business taxes, technological change, expectations of future business opportunities, and so on (follow link to our wiki page on Investment).

It is important to be able to distinguish between the money market and the market for loanable funds, as both the AP and IB syllabi xpect students to understand and explain the difference between these concepts.

Last week AP students at Shanghai American School took their final test for the class on the last Macro unit, “International Economics”. The free response question on this test was from Form B of the 2007 exam, which is written for students who take the exam outside of the United States.

Upon grading my students’ tests, I was surprised to see how poorly students did on the FRQ. The most common mistake was confusing the money market with the market for foreign currency. Read below to see the original question, along with my comments on common mistakes and the correct answer.

2007 AP Macroeconomics FRQ #1 (form B)

Assume that Australia and New Zealand are trading partners. Australia’s economy is currently in recession.

(a) Now assume that Australia begins to recover from its recession. Using a correctly labled graph of aggregate demand and aggregate supply for New Zealand, show the impact of Australia’s rising income on each of the following in the short-run.

(i) Aggregate demand in New Zealand. Explain.

(ii) Output in New Zealand

Mr. Welker: Here is where the first common mistake was made. The question asks for an AD/AS showing New Zealand’s economy, NOT Australia’s. As incomes in Australia rise, Aussies will demand more imports from NZ, meaning NZ’s net exports will rise, shifting NZ’s AD curve outward, increasing NZ’s output.

(b) Using a correctly labeled graph of the money market for New Zealand, show the effect of the output change in part (a)(ii) on the following.

(i) Demand for money. Explain

(ii) The nominal interest rate

Mr. Welker: This is the question that almost everyone screwed up on. The most common mistake was confusing NZ’s money market with the foreign exchange market for NZ’s currency. The money market, which the question is asking for, refers to the the money in circulation in New Zealand, the supply of which is determined by NZ’s central bank, the demand for which is determined by the amount of output in NZ and the public’s desire to hold money as an asset. As output increases in NZ due to higher net exports, demand for money will shift out, and if you recall the Y-axis in a money market shows the nominal interest rate, so nominal interest rates will increase as money demand shifts out.

The mistake most people made was misinterpreting the question to be asking about the foreign exchange market for NZ dollars. This market would show the price of NZ dollars in terms of Australian dollars on the Y-axes, the demand for NZ$ by Australians, and the supply of dollars by New Zealanders. This is not what the question is asking for, however, many of you included this diagram, which does not show the nominal interest rate.

(c) Assume that the price level in New Zealand rises. Given your answer to part (b)(ii), explain what will happen to real interest rates.

Mr. Welker: Here’s another question that most people messed up on. The answer is that as nominal interest rates rise while the price level is rising, we don’t know what will happen to real interest rates! Remember, real interest rate = nominal interest rate - inflation rate. Whether real interest rates rise or fall depends on the degree to which nominal interest rates and inflation rise. Therefore, the real interest rate cannot be determined.

(d) Although recovering, Australia remains in recession and its government takes no action. Indicate whether each of the following curves will shift to the left, shift to the right, or remain unchanged in the long run in Australia.

(i) Aggregate supply

(ii) Aggregate demand

Mr. Welker: I was truly shocked to see how many people got this one totally wrong. In fact, I suspect about half of you just guessed on this one, which was a surprise to me because this was something we had emphasized heavily in our class discussions; in fact you had even seen a very similar question in an FRQ a couple of units ago.

The key to knowing what this question is getting at is the phrase “its government takes no action.” This must, therefore, be referring to a “self-correction” scenario, which is based on the neo-classical theory of a vertical long-run aggregate supply curve, made possible by the downward flexibility of wages and prices.

If Australia remains in a recession, high levels of unemployment and low levels of overall spending will put downward pressure on wages and prices. As price levels fall and large number of workers are unemployed, people will begin accepting lower wages, which means input costs for firms will decrease, inducing firms to hire more workers, shifting short-run aggregate supply and output back towards the full-employment level. Since the question makes no mention of any new spending (implied by the “government takes no action” statement, meaning no fiscal or monetary stimulus is employed), there is no impact on aggregate demand.

The question simply says “indicate”, therefore the correct answers are:

(i) Aggregate supply will shift right

(ii) Aggregate demand will remain unchanged

The mistakes made on this FRQ are fairly common and simple mistakes. But this final macro test should serve as a wakeup call to some of you who may have coasted through the last few units. Macroeconomics is the harder of the two AP subjects. Last year’s classes averages .42 points lower on the macro AP exam than the micro, despite having completed Macro more recently.

Over the next 12 days, AP Econ students all over the world need to focus on their review and studies for the AP exams. To help you, I’ve put all of our review materials onto one page here on the blog. Click on the tab at the top of this page that says “Exam Prep”, and there you will find downloadable .pdf study guides for every unit in the course, as well as links to each unit’s wiki over at Welker’s Wikinomics Page. New on the wiki is a “graph bank” containing all of the graphs we’ve learned this year. As part of your exam review, please add titles and descriptions to these graphs by May 8.

Carmen submitted the following through the “Econ Help Desk“

Please help me with a student question. If the FED pursues expansionary monetary policy, lowering the nominal interest rate in hopes of spurring investment and increasing aggregate demand, how does this connect to the loanable funds market? If nominal interest rates are down, won’t real ones go down too, causing people to save less? In this case, where will the supply of loanable funds to meet investment demand come from?

Below is my reply to Carmen:

Good question… here’s my understanding, so take it as you will…

To expand the money supply the Fed will buy bonds on the open market. This increases demand for bonds, raises their prices, lowering the effective interest rate on bonds, making these securities less attractive to investors, who will sell them back to the Fed in exchange for liquid money that is now part of the money supply.

Investors will put some of their new money into banks, where interest rates are now relatively more attractive than the declining rates on government bonds. Some of the new money created by the Fed’s purchase of bonds therefore ends up in the loanable funds market, shifting the supply of loanable funds out, lowering real interest rates, increasing the quantity demanded of funds for investment and consumption, hence the expansionary impact on Aggregate Demand.

If any readers has another take on the transition from expansionary monetary policy to a decline in the real interest rate in the LF market, please leave your ideas in a comment below.

~Jason Welker

More Bold Moves from the Fed: Business Week online ediction

Here we are, the night before our test on Monetary Policy, and good ol’ Mr. Bernanke throws me a perfect blogworthy bit of news!

The Federal Reserve announced a series of steps Mar. 16 to help provide relief to a spreading credit crisis that threatens to plunge the economy into recession: The central bank approved a cut to its lending rate to financial institutions, from 3.5% to 3.25%, and created another lending facility for big investment banks to secure short-term loans.

Global financial markets appeared to react with alarm on Sunday evening. In overseas trading, the euro made new highs vs. the dollar, U.S. Treasury futures fell, and gold futures posted new record highs at $1,009.50 per ounce.

Discussion Questions:

1. Describe briefly what the article means by “a spreading credit-crisis”. How does less lending threaten to “plunge the economy into recession”?
2. Which tool of monetary policy does the term in bold refer to? Why would financial institutions ever need to borrow from the Fed?
3. Why did the euro reach “new highs vs. the dollar” on news of the US lowering interest rates? Why did gold shoot to its highest price in history on the news?

Job losses worst in five years - Mar. 7, 2008

The news late last week out of Washington was not what the White House was hoping for only a couple of weeks after the passing of a fiscal stimulus package meant to achieve exactly the opposite of what has happened. The US Labor Department released its latest numbers on employment on Friday:

There was a net loss of 63,000 jobs, which is the biggest decline since March 2003 and weaker than the revised 22,000 jobs lost in January. Economists had forecast a gain of 25,000 jobs…

“Based on today’s Employment Report, if we are not in a recession, it is a darned good imitation of one,” said Kevin Giddis, managing director of fixed income at Morgan Keegan.

So with a net loss of jobs, it may seem weird to hear that unemployment has actually fallen from 4.9% to 4.8%. How is this possible? In this case lower unemployment may indicate an even worse reality for the American economy:

The unemployment rate fell because of an increase of 450,000 people whom the government no longer counts as being part of the labor force for a variety of factors, such as that they are not currently looking for work. That drop in the size of the labor force allowed for the modest decline in unemployment, even as the household survey showed 255,000 fewer Americans with jobs than in January.

Discouraged workers point to a deep pessimism underlying households and workers in America, indicating that if we’re not already in a recession, it is only a matter of time. With the apparent failure of fiscal policy at achieving any immediate turnaround in consumer confidence, all eye’s are now on the Fed, America’s central bank, to see how Ben Bernanke will respond to the latest round of bad news.

“Even the silver lining of a falling unemployment rate has a little rust,” said Rich Yamarone, director of economic research at Argus Research. He predicted that the central bank will cut rates by a half percentage point at both its March meeting and again on April 30.

But Yamarone and some other experts questioned whether additional Fed cuts would do much to improve the employment outlook.

“We’re not in a crisis because the cost of borrowing is too high, it’s because people are afraid of lending,” said Dan Alpert, managing director of Westwood Capital, referring to the ongoing credit crunch. “At the end of the day, the Fed cuts don’t really solve the problems. They’ve already cut allot; if jobs continue to decline in face of further interest rate cuts, it’s prima facie evidence cuts aren’t effective.”

But few experts were ready to suggest the Fed would stop cutting rates at this point, given the problems in the economy and financial markets.

“The Fed has to do what it can to provide remedy and not scare the market as well,” said Mike Materasso, a senior portfolio manager at Franklin Templeton.

Central bankers face difficult decisions in times like these. While unemployment and falling growth rates pose significant problems to the American economy, the third macroeconomic evil is certainly in the minds of policymakers when deciding how to deal with the first two: inflation.

In order to lower interest rates, the Fed first has to implement expansionary monetary policy. In other words, the central bank must increase America’s money supply. How does it do this, exactly? Most commonly, the Fed uses open market operations, which is a fancy way of saying the Fed buys and sells government securities (treasury notes, bonds, etc…) on the bond market. When the Fed wishes to lower interest rates, it must inject new money into the economy, which it does by buying government bonds from the holders of those securities; namely, the public.

American banks, households, and firms, as well as foreigners all hold government debt. When the Fed wants to expand the money supply, it simply starts buying these debt securities back from the public. The increase in demand for securities drives up their prices, encouraging holders of the debt to sell their securities to the Fed, for which they receive money in exchange. In effect, the public exchanges illiquid (unspendable) debt certificates for liquid money. Now consumers have more money in their pockets to spend, firms have more to invest, and banks have more to loan out to borrowers who want to spend and invest. How do banks get rid of their new liquidity? Yep, they lower their interest rates.

In a nutshell, that’s how monetary policy works. To combat a recession and rising unemployment, the Fed simply buys bonds on the open market, injecting liquidity into the economy, which should result in more borrowing and more spending, shifting aggregate demand out, leading to growth and rising employment.

But what about that third evil, inflation? Won’t more spending lead to demand pull inflation? Usually this is not a major concern in times of a slowdown, since rising unemployment indicates the economy is producing below its full employment level of output. Expanding aggregate demand should result in increased output and stable prices. Today, however, Americans are facing other inflationary pressures, including a historically weak dollar (meaning imported goods and raw materials are more expensive than ever), and skyrocketing food and energy prices due to rising global demand for such commodities.

This all makes the job of monetary policy exceptionally challenging for Mr. Bernanke and his colleagues at the Fed. Expand the money supply too much (i.e. lower interest rates too much) and you risk accellerating inflation. Keep rates too high, and we can expect even worse employment and output numbers in the next few months.

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Recession prevention - Los Angeles Times

Much of the sub-prime debacle is hard to fathom, though the simplest explanation is probably the most correct: inadequate regulation led to excessively risky loans, which were then packaged attractively and handed on to the major financial institutions.

The policy responses, however, have been simple–right in line with a textbook analysis. Most fascinatingly, some free-market fundamentalists have called for Keynesian economic stimuli and the US government has responded. Moreover, those pursuing monetary policies have admitted that lags and the banks’ timidity in extending loans (which results in excessive excess reserves) may render the recent cut in the Fed Funds Rate ineffective.

A lot of good relevant articles are around, but you may like the following debate. What side would you be on? Continue Reading »

FT.com / Asia-Pacific / China - Pressure builds over renminbi

In IB Economics, we’re currently studying the determinants of exchange rates. One important factor in determining the demand for a particular currency is the interest rates in the country whose currency is in question relative to that of other countries.

The recent cut of the federal funds rate in the US of 25 basis points to 4.5% brought the US rates closer to China’s recently increasing interest rate of 3.32%. The upward trend of Chinese rates (up 50 basis points this year) and downward trend of American rates (down 50 basis points this year) should diminish the appeal of dollar denominated financial assets and increase the demand for those in Chinese RMB. In the currency market, we should see weakening demand for dollars and strengthening demand for RMB, as US savings and government securities are relatively less appealing due to the declining returns on those investments. With further increases in Chinese rates expected (due to high inflation), the RMB should be in greater demand, as returns on Chinese investments looks to increase as rates rise. Continue Reading »