Archive for the 'Money Market' Category

May 08 2012

Loanable Funds vs. Money Market: what’s the difference?

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 MoneyMoney Market 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):

[youtube]http://youtu.be/BoDjLCKov9I?t=43s[/youtube]

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):

[youtube]http://youtu.be/mwjvutjDhOw?t=3m25s[/youtube]

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.

68 responses so far

Dec 13 2011

Podcast: Time is Money

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

No responses yet

Aug 28 2010

“Why can’t the government just print more money?” – NOT such a silly question!

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!

36 responses so far

Jun 10 2009

The almighty bond market: Niall Ferguson’s concerns about the US deficit explained

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.

crowding-out_11

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.

crowding-out_3

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.

crowding-out_21

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:

61 responses so far

Jan 19 2009

“The Ascent of Money” – Economic historian Niall Ferguson on the Colbert Report

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!

5 responses so far

Next »