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.

First watch this video lesson, which defines and introduces the money market diagram (skip ahead to 0:43 to hear the definition and explanation of the money market):

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.

However, since the money demand curve depends on the level of transactions going on in a nation's economy in a particular period of time, an increase in government spending on infrastructure, defense, corporate subsidies, tax rebates or other fiscal policy initiatives will increase the demand for money, shifting the Dm curve rightward and driving up interest rates. The higher interest rates resulting from the greater demand for money reduces the quantity of private investment; in this way the crowding-out effect can be illustrated in the money market.

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.

Watch this video for a clear explanation of the loanable funds market and how it can be used to illustrate the crowding-out effect (skip ahead to 3:18 for a definition and explanation of the loanable funds market):

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.

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Over the weekend I watched the new Justin Timberlake movie, In Time. In this edition of Welker's Wikinomics Podcast I analyze the movie's basic premise from a macroeconomic viewpoint.

Listen to the podcast, and then answer the discussion questions at the bottom of this post.

Discussion Questions:

1. Why does increasing the supply of money cause the demand for goods and services to rise?
2. Why does increasing the supply of money ultimately cause the supply of goods and services to fall?
3. When would an increase in the money supply be most inflationary, when an economy is producing close to its full employment level or when an economy is experiencing a recession? Explain.
4. With the help of a money market diagram and an aggregate demand / aggregate supply diagram, illustrate the effects of Will and Silvia's re-distribution of time on the Ghetto's economy.
5. According to Friedman, expansionary monetary policy cannot contribute to a nation's long-run economic growth. What types of government policies can be implemented to promote economic growth in a nation?

Podcast Credits: 

• Intro song: The Rolling Stones – Time is On My Side
• Ending song: Pink Floyd – Money
• Milton Friedman quotes – Donahue, 1980

I received the following email today, which gave me a great excuse to write a blog post about monetary policy! My reply to the teacher is below.

Jason,

I hate to bug you, but I have a question. I am a first year AP Econ teacher and I know something is going to come up right away and I want to explain it in the simplest way. “Why can’t the govt. just print more money?” I know the inflation part of it, but when I am reading to look for quality ways of explaining it, I see plenty of information about it, but I can’t grasp it. Principle 9 in Mankiw text states “Prices rise when the govt. prints too much money.” I feel like a dumb kid and I am supposed to teach this!!!!

If you can help, great, if not, I will figure it out.

Thanks,
Teacher

Dear Teacher,

I love your question! It is definitely one of those issues that gets glossed over in most economics textbooks. Or it is assumed that the money supply diagram makes it obvious why excessive monetary growth leads to inflation. But I agree, this is one of those things that for the first couple of years I taught economics, I probably didn't really understand all that well either! So let me try to break it down in plain English for you. This will be good for me too, cause I always understand things more clearly myself after writing them (which is why writing a textbook is about the best PD I've every undertaken!)

So, here it goes:

Printing money and its effect on inflation is a bit more complicated than it sounds. In fact, it is the US treasury that prints money, but it is the Federal Reserve that determines how much money is actually in circulation in the economy. Money printed by the Treasury is distributed to the twelve Federal Reserve banks around the country. The treasury and the government of which it is a part does not have any say on how much money actually gets injected into the economy, as monetary policy decisions are left up to the Federal Reserve.

Traditionally, the Fed has one tool for injecting new money into the economy, a tool known as “open market operations”. (I say traditionally, because in the last three years the Fed has devised numerous new ways to “inject liquidity” into the economy, which I will not get into now). To increase the nation's money supply, the Fed buys US government bonds on the open market from commercial banks. Commercial banks invest some of American households' savings into government bonds just like they invest some of our money into individuals and businesses by making loans and charging interest on those loans. Commercial banks will want to buy government bonds if the interest on them rises and will want to sell those bonds when the interest rate falls.

If the Fed want to increase the money supply to stimulate spending in the economy, it will announce an open market purchase of bonds. When the Fed buys bonds, the demand for bonds increases, raising their prices and lowering their effective interest rate. As the interest on government bonds falls as a result of the Fed's open market operations, banks find them less desirable to hold onto as investments and therefore sell them to the Fed in exchange for, you guessed it, liquid money, fresh off the printing presses!

Remember, the money printed at the Treasury and held at the Fed was NOT part of the money supply, since it is out of reach of private borrowers. But as soon as the Fed buys bonds with that money, it is deposited into commercial banks' excess reserves and is therefore now in the commercial banking system and therefore part of the money supply. So, “printing money” does not immediately increase the money supply since newly printed money only ends up in the Fed; only once the Fed has undertaken an expansionary monetary policy (an open market bond purchase) does the newly printed money enter the money supply.

Now, commercial banks have just sold their illiquid assets (government bonds) to the Fed in exchange for liquid money. Picture the money market diagram and you will see the money supply increasing.

So the next question is, why does this lead to inflation?

Banks now hold more excess reserves, most of which are kept on reserve at their regional Federal Reserve bank. Reserves held at the Fed do NOT earn interest for the banks, and therefore actually lose value over time as inflation erodes the purchasing power of these idle reserves. Banks, of course, want to invest these reserves to earn interest beyond the rate of inflation and thereby create earn them revenue. In order to attract new borrowers, commercial banks, whose reserves have increased following the Fed's bond purchase, must offer borrowers a lower interest rate. The increase in the supply of money leads to a decrease in the “price” of money, i.e. the interest rates banks charge borrowers.

So here we see why an increase in the money supply leads to lower interest rates. With greater excess reserves, banks must lower the rate they charge each other (the federal funds rate) and thus the prime rate they charge their most credit-worthy borrowers and all other interest rates in the economy, in order to attract new borrowers and get their idle reserves out there earning interest for the bank.

Lower interest rates create an incentive for firms to invest in new capital since now more investment projects have an expected rate of return equal to or greater than the new lower interest rate. Additionally, the lower rates on savings discourages savings by households and thereby increases the level of household consumption. Households find it cheaper to borrow money to purchase durable goods like cars and it also becomes cheaper to buy new homes or undertake costly home improvements. So we begin to see investment and consumption rise across the economy as the increase in the money supply reduces borrowing costs and decreases the incentive to save. Aggregate demand has started to rise.

Additionally, the lower rate on US government bonds resulting from the Fed's open market purchase reduces the incentive for foreign investors to save their money in US bonds and in US banks, which are now offering lower interest rates. Falling foreign demand for the dollar causes it to depreciate. A weaker dollar makes US exports more attractive to foreign consumers, so in addition to increased consumption and investment in the US, net exports begin to rise as well, further increasing aggregate demand.

Increasing the money supply (not so much by printing money rather because of the “easy money” policy of the Fed), leads to increased consumption, investment, and net exports, and therefore aggregate demand in the economy. The rising demand among domestic consumers, foreign consumers, and domestic producers for the nation's output puts upward pressure on prices as the nation's producers find it hard to keep up with the rising demand. Once consumers start to see prices rising, inflationary expectations will further increase the incentive to buy more now and save less, leading to even more household consumption. Firms see price rises in the future and increase their investment now to meet the expected rises in demand tomorrow.

It does not take much for inflation to accelerate in such an environment. If the the government and the Fed do not slow down the increase in the money supply (STOP THE PRINTING PRESSES!) then soon enough workers will begin demanding higher wages and resource costs will start to increase in all sectors of the economy, causing the nation's aggregate supply to decline as firms find it harder to cover their rising costs. Now we have both demand-pull AND cost push inflation! The weaker currency also makes imported raw materials more costly to firms, further adding to the inflationary environment. An inflationary spiral is now underway!

Milton Friedman said that “inflation is always and everywhere a monetary phenomenon”. Controlling the rate of growth in the money supply, say the monetarists, will assure that the fluctuations in the business cycle will be mild and periods of dramatic inflation and deflation can be avoided. Stable money growth should lead to stable economic growth. But as soon as we start running the printing presses inflation will not be far behind. On the flip-side, contractionary monetary policies should in theory lead to the exact opposite of what I describe above and cause a deflation. If a central bank were to tighten the money supply too much, interest rates would rise, investment, consumption and net exports would fall, and falling prices would force firms to lay off workers, leading to high unemployment and an economic contraction.

I'll leave you with one question to ponder (the answer to which would require a much longer article than this one!). If Friedman was right, and increasing the money supply will always and everywhere lead to inflation, then how is it that the monetary base in the United States increased by 142% between 2008 and 2009, yet inflation declined over the same period and fell to as low as -2% in mid-2009? That's right, the money supply more than doubled, yet the economy went into deflation. Was Friedman missing something in his calculation that monetary growth always leads to price level increases? In other words, is an open market purchase of bonds by the Fed all that is needed to stimulate demand during a recession? Perhaps Friedman, who died in 2006 right before the US entered the Great Recession, would have to re-consider his famous quote if he could see the effect (or lack of effect) of America's unprecedented monetary growth over the last three years!

Harvard Economist Niall Ferguson appeared on CNN's GPS with Fareed Zakaria over the weekend. Ferguson has stood out among mainstream economists lately in his opposition to the US fiscal stimulus package, an $880 billion experiment in expansionary Keynesian policy. While economists like Paul Krugman argue that Obama's plan is not big enough to fill America's “recessionary gap”, Ferguson warns that the long-run effects of current and future US budget deficits could lead the US towards economic collapse. This blog post will attempt to explain Ferguson's views in a way that high school economics students can understand.

Government spending in the US is projected to exceed tax revenues by $1.9 trillion this year, and trillions more over the next four years. An excess of spending beyond tax revenue is known as a budget deficit, and must be paid for by government borrowing. Where does the government get the funds to finance its deficits? The bond market. The core of Ferguson's concerns about the future stability of the United States economy is the situation in the market for US government bonds. According to Ferguson:

One consequence of this crisis has been an enormous explosion in government borrowing, and the US federal deficit… is going to be equivelant to 1.9 trillion dollars this year alone, which is equivelant to nearly 13% of GDP… this is an excessively large deficit, it can't all be attributed to stimulus, and there's a problem. The problem is that the bond market… is staring at an incoming tidal wave of new issuance… so the price of 10-year treasuries, the standard benchmark government bond… has taken quite a tumble in the past year, so long-term interest rates, as a result, have gone up by quite a lot. That poses a problem, since part of the project in the mind of Federal Reserve Chairman Ben Bernanke is to keep interest rates down“

There's a lot of information in Ferguson's statements above. To better understand him, some graphs could come in handy. Below is a graphical representation of the US bond market, which is where the US government supplies bonds, which are purchased by the public, commercial banks, and foreigners. Keep in mind, the demanders of US bonds are the lenders to the US government, which is the borrower. The price of a bond represents the amount the government receives from its lenders from the issuance of a new bond certificate. The yield on a bond represents the interest the lender receives from the government. The lower the price of a bond, the higher the yield, the more attractive bonds are to investors. Additionally, the lower the price of bonds, the greater the yield, thus the greater the amount of interest the US government must pay to attract new lenders.

Ferguson says that the price of US bonds has “taken a tumble”. The increase of supply has lowered bond prices, increasing their attractiveness to investors who earn higher interest on the now cheaper bonds. Below we can see the impact of an increase in the quantity demanded for government bonds on the market for private investment.

Financial crowding-out can occur as a result of deficit financed government spending as the nation's financial resources are diverted out of the private sector and into the public sector. Granted, during a recession the demand for loanable funds from firms for private investment may be so low that there is no crowding out, as explained by Paul Krugman here.

But crowding out is not Ferguson's only concern. The increase in interest rates caused by the US government's issuance of new bonds could lead to a decrease in private investment in the US economy, inhibiting the nation's long-run growth potential. But the bigger concern is one of America's long-run economic stability. If the Obama administration does not put forth a viable plan for balancing its budget very soon, the demand for US government bonds could fall, which would further excacerbate the crowding-out effect, and eliminate the country's ability to finance its government activities. In other words, such a loss of faith could plunge the United States into bankruptcy.

Fareed Zakaria asks Ferguson:

“Is it fair to say that this bad news, the fact that we can't sell our debt as cheaply as we thought, overshadows all the good news that seems to be coming?”

Ferguson's reply:

The green shoots that are out there (referring to the phrase economists and politicians have been using to describe the signs of recovery in the US economy) seem like tiny little weeds in the garden, and what's coming in terms of the fiscal crisis in the United States is a far bigger and far worse story.

Finally Fareed asks the question everyone wants to know:”What the hell do we do?”

Ferguson:

One thing that can be done very quickly is for the president to give a speech to the American people and to the world explaining how the administration proposes to achieve stabilization of American public finance… the administration doesn't have that long a honeymoon period, it has very little time in which it can introduce the American public to some harsh realities, particularly about entitlements and how much they are going to cost. If a signal could be sent really soon to the effect that the administration is serious about fiscal stabilization and isn't planning on borrowing another $10 trillion between now and the end of the decade, then just conceivably markets could be reassured.

Ferguson is saying that only if the Obama administration begins taking serious steps towards balancing the US government's budget can it hope to stave off an eventual loss of faith among America's creditors (and thus a fall in demand for US bonds). It will be a while before tax revenues are high enough to finance the US budget. But if the country does not begin working towards such an end immediately, it may find itself unable to raise the funds to pay for such public goods as infrastructure, education, health care, national defense, medical research, as well as the wages of the millions of government employees. In other words, the US government could be bankrupt, and its downfall could mean the end of American economic power.

The power of the bond market should not be underestimated. America's very future depends on continued faith in its financial stability and fiscal responsibility.

Discussion Questions:

1. Why do you think the US government has such a huge budget deficit this year? ($1.9 trillion) Previously, the largest budget deficit on record was only around $400 billion.
2. How does the issuance of new bonds by the US government lead to less money being available to private households and firms?
3. Do you think investors will ever totally lose faith in US government bonds? Why or why not?
4. In what way is the government's huge budget deficit a “tax on teenagers”? In other words, how will today's teenagers end up suffering because of the federal budget deficit?

To learn more about the power of the bond market, watch Niall Ferguson's documentary, The Ascent of Money. The section on the bond market can be viewed here:

Niall Ferguson | January 13th | ColbertNation.com

Harvard Economic historian Niall Ferguson on the Colbert Report explains the concept of “invisible money”. I just bought Ferguson's new book, The Ascent of Money over the holidays and am looking forward to reading it. In his interview with Colbert, the historian explains that money as we know it is only worth something because we think it is worth something. Colbert can't seem to believe that there's no underlying intrinsic value such as a gold standard backing the value of his dollar bill, which has in fact been the case since the early 1970s in America.

Ferguson says that money represents a relationship of trust between a creditor and debtor, which is one reason there seems to be so little money available for spending in the economy today. Macroeconomic uncertainty and low consumer confidence are the main causes of the today's global recession. In a climate of fear and uncertainty, the trust underpinning our monetary system dries up. Banks are afraid to make loans, consumers are afraid to make big purchases, and firms are afraid to make capital investments. The result? Low aggregate demand, falling income and output and rising unemployment.

Paul Krugman, in his latest book the The Return of Depression Economics argues that the fundamental solution to a financial crisis such as today's is to drastically increase the money supply. The $350 billion that the Bush administration has pumped into the financial system already seems to have done very little to prime the economic pumps, so to speak. To restore trust, and thus stimulate real spending in the economy once again, creating income, output, and real employment, massive monetary stimulus will be needed. A trillion dollar stimulus package by an Obama administration should not come as a surprise, should it be put to the nation to vote on in the near future.

Our love of money is a little less impassioned than it was a few years ago, according to Ferguson. Not because money no longer serves an essential function in our lives, rather because we have lost much of our faith in our monetary system's ability to create and maintain stable economic conditions and long-run economic growth. To restore Americans' faith in the almighty dollar and put the economy back on a track towards stability and growth, a massive fiscal and monetary stimulus is needed. Okay, time to start reading The Ascent of Money and to watch less Comedy Central!

The Huffington Post – Economic Honor Roll

The liberal blog and news site, Huffington Post, has an interesting post sharing excerpts from the writings of some prominent economists over the last several years who foresaw the economic meltdown now underway in the world's financial markets. It's interesting to read these passages today and realize that the financial crisis that seemed to take Washington by such surprise in the last few weeks was something economists have seen coming for quite some time.

Nouriel Roubini, NYU professor of economics: from “The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster” (subscription req'd), February 5, 2008

…it is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200 plus subprime lenders that have gone bankrupt.[...]

Ninth, the “shadow banking system” (as defined by the PIMCO folks) or more precisely
the “shadow financial system” (as it is composed by non-bank financial institutions) will
soon get into serious trouble.[...]

Tenth, stock markets in the US and abroad will start pricing a severe US recession -
rather than a mild recession – and a sharp global economic slowdown.[...]

A near global economic recession will ensue as the financial and credit losses and the
credit crunch spread around the world. Panic, fire sales, cascading fall in asset prices will
exacerbate the financial and real economic distress as a number of large and systemically
important financial institutions go bankrupt. A 1987 style stock market crash could occur
leading to further panic and severe financial and economic distress.
In this meltdown scenario US and global financial markets will experience their most
severe crisis in the last quarter of a century.

Paul Krugman, New York Times columnist (and winner of the 2008 Nobel Price for Economics)

Krugman has been warning about the dangers of the housing bubble for years, and the terrible toll it could take on the economy when it pops. Here is a Krugman warning from August 29, 2005:

These days Mr. Greenspan expresses concern about the financial risks created by “the prevalence of interest-only loans and the introduction of more-exotic forms of adjustable-rate mortgages.” But last year he encouraged families to take on those very risks, touting the advantages of adjustable-rate mortgages and declaring that “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.

If Mr. Greenspan had said two years ago what he's saying now, people might have borrowed less and bought more wisely. But he didn't, and now it's too late. There are signs that the housing market either has peaked already or soon will. And it will be up to Mr. Greenspan's successor to manage the bubble's aftermath.

How bad will that aftermath be? The U.S. economy is currently suffering from twin imbalances. On one side, domestic spending is swollen by the housing bubble, which has led both to a huge surge in construction and to high consumer spending, as people extract equity from their homes. On the other side, we have a huge trade deficit, which we cover by selling bonds to foreigners. As I like to say, these days Americans make a living by selling each other houses, paid for with money borrowed from China.

One way or another, the economy will eventually eliminate both imbalances.

Joseph Stiglitz, Nobel Prize-winning economist: Washington Post, “The Iraq War Will Cost Us $3 Trillion, and Much More,” March 9, 2008

We face an economic downturn that's likely to be the worst in more than a quarter-century.

Until recently, many marveled at the way the United States could spend hundreds of billions of dollars on oil and blow through hundreds of billions more in Iraq with what seemed to be strikingly little short-run impact on the economy. But there's no great mystery here. The economy's weaknesses were concealed by the Federal Reserve, which pumped in liquidity, and by regulators that looked away as loans were handed out well beyond borrowers' ability to repay them. Meanwhile, banks and credit-rating agencies pretended that financial alchemy could convert bad mortgages into AAA assets, and the Fed looked the other way as the U.S. household-savings rate plummeted to zero.

It's a bleak picture. The total loss from this economic downturn — measured by the disparity between the economy's actual output and its potential output — is likely to be the greatest since the Great Depression.

Daniel Altman, author, economic journalist and Huffpo blogger, from “Contracts So Complex They Imperil The System”, February 24, 2002

When companies that rack up huge hidden debts and traders who illicitly amass mountains of risk are exposed, Wall Street's big players rush to cut their losses and collect on their debts. If that kind of rush were ever to result in a shortage of cash, it would paralyze the financial system. Stock markets would tumble and banks would close, putting the savings of households at risk.

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

Inflation Reality Check(The Korea Times)

Harvard Economist Kenneth Rogoff points out that inflation is a major problem in many of the world's largest economies today:

Inflation in Russia, Vietnam, Argentina, and Venezuela is solidly in double digits, to name just a few possibilities.

Indeed, except for deflation-ridden Japan, central bankers could meet just about anywhere and see high and rising inflation. Chinese authorities are so worried by their country's 7 percent inflation they are copying India and imposing price controls on food.

Even the United States had inflation at 4 percent last year, though the Federal Reserve is somehow convinced that most people won't notice.

Usually, inflation can be combatted with restrictive monetary policy, or the selling of bonds on the open market, which reduces the money supply, raises interest rates and slows down consumption and investment, and thus the pressure on prices in the economy. Today, however, the US Fed is in the process of expanding money supply and lowering interest rates, in an attempt to avoid a recession at home.

In a world of isolated economies, the US monetary policy would only affect the US economy; however, today the US economy finds itself intertwined in complex ways with other economies of the world.

America's inflation would be contained but for the fact that so many countries, from the Middle East to Asia, effectively tie their currencies to the dollar. Others, such as Russia and Argentina, do not literally peg to the dollar but nevertheless try to smooth movements.

As a result, whenever the Fed cuts interest rates, it puts pressure on the whole “dollar bloc” to follow suit, lest their currencies appreciate as investors seek higher yields.

Looser U.S. monetary policy has thus set the tempo for inflation in a significant chunk ? perhaps as much as 60 percent ? of the global economy.

The reason other countries must mimic US monetary policies has to do with exchange rates, which many countries try to peg to varying degrees to the value of the dollar. One of the determinants of exchange rates is relative interest rates between countries. If the US lowers interest rates, and a country like Argentina keep rates high, global investors looking for a return on their savings will take their money out of US savings accounts and deposit it in Argentinian savings accounts, where they can earn a greater interest rate. In order to save in Argentina, investors need to convert their dollars to Argentinian pesos, driving up demand for pesos and the dollar/peso exchange rate. A stronger peso could have negative impacts on demand for Argentina's exports as they become more expensive to foreign consumers. In order to avoid appreciation of its currency and declining demand for its exports, Argentina is thus forced to lower its own interest rates as the Fed cuts those in the US.

When you consider that much of the world adjusts its currency in relation to the dollar, you can see how an easy money policy in the US could lead to falling interest rates worldwide, triggering all sorts of new consumption and investment, driving price levels ever higher.

There is hope for curing the inflation problem. Relief may come at a price for Americans, however:

If the U.S. tips from mild recession into deep recession, the global deflationary implications will cancel out some of the inflationary pressures the world is facing.

Global commodity prices will collapse, and prices for many goods and services will stop rising so quickly as unemployment and excess capacity grow.

Of course, a U.S. recession will also bring further Fed interest-rate cuts, which will exacerbate problems later. But inflation pressures will be even worse if the U.S. recession remains mild and global growth remains solid.

Once again the Fed's challenge of balancing unemployment, inflation, growth and recession is made clear. The choice of several major world economies to affix their currencies' values to that of the dollar makes the challenge ever more dire for Mr. Bernanke.

Discussion Questions:

1. If a US interest rate cut is not matched by countries that tie their currency to the dollar, what would happen to the value of those countries' currencies?
2. Why are lower world interest rates inflationary?
3. What will happen to the value of the Euro if the ECB does not start cutting interest rates soon?
4. Why might a US recession counter the inflationary pressure caused by rising food and energy prices and loose monetary policy in the US and other nations?

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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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