1. Principles of Economics
Power Point Presentation
Chapter 11
Money and the Business Cycle I
March 26, 2007
© J. Patrick Gunning

2. Introduction: Goals Of The Chapter (1)
Main goal: to present a simple monetary theory of the business cycle. A more complex theory is presented in chapter 12.
1. Business cycle: A significant increase in “business activity” is followed, after a time, by a decrease.
Business activity: producing, exchanging and employing resources.
2. Monetary theory of the business cycle: the idea that a business cycle is caused by a large, unexpected increase in the quantity of money.

3. Introduction: Goals Of The Chapter (1)
Necessary subsidiary goal: to present the quantity theory of money.
Quantity theory of money: a substantial rise (fall) in the quantity of money, other things equal, is practically always followed by a rise (fall) in prices.

4. Introduction: Changes In Business Activity Are Usually Slow
Entrepreneurs have an incentive to adjust to changes in market conditions by changing the prices of consumer goods and causing resources to shift.
Changes in business activity are usually slow because changes in consumer wants and technology are ordinarily gradual.
Entrepreneurs ordinarily have sufficient time to adjust to such changes.
Even more fundamental change in technology are slow enough to give entrepreneurs time to adjust. As a result, the benefits of technological advance are ordinarily spread out over a long period of time.

5. Entrepreneurs Usually Have Time To Cause Coordination
Coordination requires communication through markets and prices – agreements to buy and sell. It also requires long term planning.
Producing entrepreneurs use the signals given by intermediary entrepreneurs as the basis for predicting future prices of goods and resources.
Many market participants – for example, producers and consumers – can respond to these communications like the driver of a car responds to her speedometer dial. Or they can negotiate prices.

6. There Is A Tendency Toward Complete Coordination
Complete coordination is impossible because of continuing changes in wants and technology.
However, economists are justified in assuming that there is a tendency toward more complete coordination.

7. Correct Planning Depends On Accurate Signaling
Producing entrepreneurs make short and long-term plans.
Examples:
Short term: a housewife who enters the work force.
Long-term plans: builders of bridges and skyscrapers and researchers.
The signals of intermediary entrepreneurs are important to both.
But errors can be particularly significant in the case of long term plans.

8. Signals and Estimates of Future Benefits and Opportunity Costs
The signals people receive and send are about quantities of money that they are willing to pay or accept.
When a person sends a signal, he is communicating his willingness to buy or sell based on his estimates of future benefits and opportunity costs.
When a person receives a signal, its meaning depends on his estimates of future benefits and opportunity costs.

9. Money as a Measuring Rod
To estimate future benefits and opportunity costs, individuals use the measuring rod of money.
The length of a measuring rod is not fixed like the length of tape measure used in building a house.
It can be changed by a change in the quantity of money.

10. A Measuring Rod in Construction
Suppose that after a builder had begun to build a house, someone unexpectedly changed the length of an inch or meter.
After this happened the new construction would not be coordinated. The house may have to be torn down and rebuilt.
An analogous event occurs when the measuring rod of money changes due to an increase in the quantity of money

11. An Unexpected Change In Money Quantity Disrupts Signaling, Causing Errors And Greater Dis-coordination
When the quantity of money increases unexpectedly, the signaling and responses to signaling are disrupted.
This practically always causes greater dis-coordination.
Producing entrepreneurs make these errors because they receive what are essentially false signals from intermediary entrepreneurs.

12. Changes In Money Cause A Business Cycle
The business cycle is basically a manifestation of dis-coordination due to false signals that lead to mistakes in planning.
People make mistakes and cause a rise in business activity.
Then as they make adjustments to avoid the worst effects of their mistakes, there is a fall in business activity.
Business activity returns to normal only when entrepreneurs resume their normal pattern of errors.

13. First Topic: How The Central Bank Can Increase The Quantity Of Money

14. The Concept of Money Used in the Quantity Theory (1)
1. Currency: central bank notes (in the U.S. these are federal reserve notes plus token coins.
2. Transferable deposits that are in
circulation.

15. What Is The Quantity Of Money?
It is the total amount of currency plus transferable deposits in circulation.
In circulation: money owned by private individuals and available to be used in market interaction.
Out of circulation: money owned by banks or by a central bank or when it is hoarded.
It includes central bank notes that are in bank vaults and drawers.
Hoarding: the act of keeping currency out of circulation by a private holder of money (we disregard hoarding in this discussion).

16. Counting Money Think of all the money that you have.
1. You have currency, in your pocket, wallet, purse, at home.
2. You have transferable deposits. That is, you have balances at banks and other depository institutions that you can instruct your bank or institution to transfer to others.
Add your money to the money of others, including entrepreneurs.

17. A Central Bank The governments of most nations have a central bank.
Recall the three typical duties of a central bank:
1. To issue paper money and coins.
2. To regulate ordinary banks.
3. To control the quantity of money.

18. Two Ways For The Central Bank To Increase The Quantity Of Money
1. Create additional currency (print additional central bank notes and mint additional token coins).
2. Induce banks to increase the amount of transferable deposits.
Its status as a regulator enables it to causes banks to create additional money.
It uses a combination of both ways and the process is complicated.

19. Creating Additional Money By Putting New Currency In Circulation (1)
How the central bank can put new currency into circulation:
1. Pay its employees in currency.
2. Lend it to banks by reducing the discount rate. The banks relend it to borrowers either in the form of currency or transferable deposits.
3. Use currency to pay for government projects.
4. Buy government bonds or other assets.
Discount rate: the rate of interest at which a central bank lends to banks.

20. Creating Additional Money By Putting New Currency In Circulation (2)
The central bank ordinarily puts new currency into circulation by buying government bonds.
Due to its regulations of banks, this induces banks to create additional transferable deposit.

21. Inducing Banks To Create Money
The central bank can cause banks to create new transferable deposits because of its power to regulate banks.
To understand this power, we must first understand two things:
1. How an ordinary bank can create transferable deposits.
2. How regulation by the central bank restricts transferable deposit creation by banks.

22. A banker performs two services for customers:
How An Ordinary Banker Can Create Money: The Operations Of A Modern Bank
A banker performs two services for customers:
She transfers currency or rights to withdraw currency to others when asked to do so.
She receives transfers of currency or rights to withdraw currency from others and credits them to the customer’s account.

23. Money Creation
Recall that a gold money warehouse can create credit money by issuing gold ownership certificates that are unbacked by reserves of gold and putting them into circulation.
A modern banker can create additional credit money by issuing transferable deposits that are unbacked by reserves of currency and putting them in circulation.

24. An Example A new customer deposits $100 in currency.
$100 in currency is taken out of circulation; $100 in new transferable deposit is created. There is no change yet in the quantity of money.
Now suppose that the bank is encouraged to lend out $50 in new transferable deposits, perhaps because it expects the new depositor to keep $50 of the new deposit in the bank.
Note that the original $100 is backed by currency.
The additional $50 is not.
The bank has created an additional $50 in money.

25. 2. Central Bank Restrictions: Reserves And The Reserve Requirement
Reserves: the amount of currency and other assets that a bank keeps in reserve to back its transferable deposits.
Reserve requirement or required reserve ratio: a legal requirement, usually enforced by a nation’s central bank, that requires banks to keep a fixed per cent of their transferable deposits in the form of reserves, such as currency. For example, 20%.

26. Fractional Reserve Financial System
Required reserves: the reserves of currency and other assets that the central bank requires an ordinary bank to hold.
Keeping required reserves: holding currency and other assets specified as reserves by the nation’s central bank.
Fractional reserve financial system: a system in which the law specifies that a bank need only keep a per cent of its transferable deposits in the form of reserves.

27. The Balancing Act Of The Typical Bank Manager
1. On the one hand: he tries to keep sufficient reserves to meet the reserve requirement.
2. On the other hand; he tries to lend as much as possible in order to maximize his interest income.
Goal: to be fully loaned up.
Fully loaned up bank: a bank that is lending as much as is allowed according to the central bank regulation.

28. What If The Bank Runs Short Of Currency Reserves?
Bank run: a decision by a large share of a bank’s deposit customers to demand currency in exchange for their transferable deposits.
What a bank can do if faced with a bank run:
It can borrow reserves from other bankers. (We discuss this market for reserves below.).
It can borrow from the central bank.
If necessary, the central bank can create additional currency to lend.
The central bank is a lender of last resort.

29. No Bank Runs Today
Lender of last resort service: the service performed by a central bank of lending to a bank in the event that the bank cannot meet its obligation to depositors.
The central bank backs up the commitment by restricting risky loans and by auditing.
Deposit insurance: a separate agency [(The Federal Deposit Insurance Corporation (FDIC)] insures insurance for depositors in banks that if the banker does not keep her promise to allow transfer or withdrawal of deposits, the central bank will do so. Insurance is paid for by a fee assessed to banks.

30. Regulation Of Banks And Insurance For Depositors
How can a depositor be sure that a banker who lends out most of the currency she receives will be able to redeem her transferable deposits?
1. The depositor knows that the central bank regulates the banks.
2. The depositor relies on the mandatory insurance of deposits.

31. How Much Money Can The Banking System Create?
Under a fractional reserve system, which practically all nations have, banks can create money.
To see how this can be done, consider three thought experiments.

32. Thought Experiment I: A System With Two Banks (1)
Assume that the two banks are fully loaned up. The central bank buys a government bond for $100 from two employees, one at each bank.
The banks transform the currency into transferable deposits of the same amount.
If the reserve requirement was 20%, each banker could conceivably make new loans of $400 without violating the reserve requirement.
But a bank might be afraid that its customers would transfer the deposits to customers at the other bank.
In that event, the bank could not meet the reserve requirement.

33. Thought Experiment I: A System With Two Banks (2)
Suppose that the banks make the loans anyway.
Suppose further that borrowers at each bank spend their money by transferring half ($200) to customers of the first bank and the other half to customers of the second bank.
Then each bank would receive just enough new deposits to cover its liabilities to those who demand payment.

34. Thought Experiment I: A System With Two Banks (3)
A variation.
Suppose that borrowers at Bank A spend their money by transferring ¼ ($100) to customers of Bank A ¾ ($300) to customers of the Bank B.
Customers of the Bank B transfer ½ ($200) to customers of the Bank B and ½ ($200) to customers of Bank A.
Then Bank A would not be able to meet its reserve requirement. It would $100 short of reserves.
Bank B would have excess reserves of $100.
Bank B could lend $100 reserves to Bank A, enabling both banks to meet the reserve requirement.

35. Thought Experiment II: A System With A Hundred Identical Banks (1)
Assume that all 100 banks are of equal size and operation.
The central bank buys government bonds so that $100 in currency is deposited in each bank.
The reserve requirement is 20%
Each bank increases loans by $400.
Although each borrower would transfer most of his borrowed deposits away from the lending bank to other banks, each bank would receive deposits from the other banks.

36. Thought Experiment II: A System With A Hundred Identical Banks (2)
It is possible that each bank would have just enough new deposits to cover its liabilities to those who demand payment.
If so, the banks taken together could increase transferable deposits by $50,000.
$10,000 in additional central bank notes would lead to $50,000 in additional transferable deposits.
The central bank notes would not be part of the money in circulation. They would be held in reserve.

37. Thought Experiment III: A System With A Hundred Different Banks
Make the same assumptions as in thought experiment #2 except that 100 banks differ in size and operation.
Some banks would have excess reserves; some banks would be short on reserves.
The federal funds market: a market in which banks with excess reserves lend to banks that are short of reserves. Usually the time of the loan is “overnight.”
Borrowing and lending in the federal funds market would enable all banks to meet their reserve requirement. And indeed it does.

38. Definitions
Excess reserves: reserves in excess of those required by the central bank.
Short of reserves: the characteristic of a bank that does not own sufficient reserves to meet the reserve requirement of the central bank.
Federal funds market: a market in which banks with excess reserves lend to banks that are short of reserves.

39. Conclusion: Multiple Deposit Creation From New Currency
All banks, taken together, could create a multiple of the initial amount of new currency that is put into circulation by the central bank.
If banks stay fully loaned up, the central bank can cause a multiple increase in the quantity of money by purchasing government bonds with additional currency.

40. The Deposit Multiplier (2)
If the reserve requirement was 20%, the banks taken together could increase transferable deposit by $50,000.
If the reserve requirement was 10%, the banks taken together could increase transferable deposits by $100,000.

41. The Deposit Multiplier (3)
Deposit multiplier: the ratio of (a) the maximum amount of transferable deposits that a central bank can cause to be changed to (b) a given change in the amount of currency.
The deposit multiplier equals the reciprocal of the reserve requirement.
Dm = 1/RR

42. Ways Of Controlling The Quantity Of Money
1. Open market operations: the central banks’ decision to buy or sell government bonds.
2. Changing the reserve requirement.
3. Changing the discount rate.
By far the most commonly used of these is the first.

43. New Topic: Introduction To The Quantity Theory Of Money
Goal of this part: To describe the observations by early economists of the effects of increases in the quantity of gold or silver under a commodity standard.

44. Some Definitions (1)
International gold standard: a system of exchange in which gold is the international standard, or money, for making exchanges. If you buy goods from a foreign country, you must pay in gold coin or bullion.
This standard existed throughout the 19th century until After that, there were fits and starts. But the nations never fully returned to it. Today there is no international standard.

45. Some Definitions (2)
Inflation: an increase in the total price of a bundle of the typical goods bought by consumers.
Deflation: a decrease in the total price of a bundle of the typical goods bought by consumers.

46. Trade Surplus And Deficit
Trade surplus: exports in terms of the standard exceeds imports during some period of time.
Under the international gold standard, gold would flow into the country as foreigners paid for our exports.
Trade deficit: imports in terms of the standard exceeds exports during some period of time.
Under the international gold standard, gold would flow out of the country as nationals paid for our imports.

47. Gold Standard In The Nineteenth Century
Nations used gold coins and representative money inside their nation.
In international trade, importers and exporters used gold or silver bars and ingots.

48. Observations Of Inflation And Deflation Under A Gold Standard
Net inflow of gold would cause inflation. Net outflow would cause deflation.
Examples:
Increase in gold because value of exports exceeded value of imports.
Spanish plunder of Peru’s gold in the 16th century.
Gold miners in the U.S. The California gold rush began in the 1848.
Later periods: the issue of credit money to finance wars and other government spending would cause inflation in terms of the credit money.

49. Figure 11-1

50. Taiwan Inflation Rate

51. Taiwan Hyperinflation

52. Recent Korean Consumer Prices

54. New Subtopic: Quantity Independ-ence Characteristic Of Money
Observation: in spite of the inflow and outflow of money and of inflation and deflation; gold, silver and credit money continued to provide services as a medium of exchange, store of value, and unit of accounting.
Quantity Independence Principle: money can perform its services no matter how much of it there is.

55. Cash Holding And The Price Level
Personal cash holding: the amount of currency plus transferable deposit that a person owns.
Total cash holding: the amount of currency plus transferable deposit that all people together own.
Cash holding equals the total amount of money in an economy.
If the price level was twice as high, people would want to hold twice as much ljhmoney.
If the price level was one half as high, people would be happy to hold one-half the amount of money.

56. Money As A Veil Definitions:
Veil of absolute prices: the actual prices of
goods and resources in markets.
Relative prices: the prices of goods and resources in terms of each other.
Money veils the relative prices. Relative prices could be the same but the veil could be large (high absolute prices) or small (low absolute prices).

57. Two Essential Services Of Relative Money Prices
1. They help people identify the opportunity costs of different goods and resources.
2. They help people communicate their willingness to buy and sell goods and resources.
Because relative money prices facilitate coordination, both money and accurate relative prices are essential for coordination and economic growth.

58. Why Worry About A Change In Money Quantity?
Question: If money is a veil, why worry about increasing or decreasing the quantity of money?
Answer: Because money helps people calculate by helping them identify opportunity costs and by helping them communicate their willingness to buy and sell goods and resources.
A sudden change would disrupt relative prices.
In turn, peoples’ calculations and communications would be disrupted. The result would be dis-coordination.
Economic growth would be lower.

59. New Topic: Representing The Quantity Theory Mathematically
Reminder of the quantity theory of money:
This is the proposition that an increase (decrease) in the quantity of money, other things equal, causes inflation (deflation).

60. The Quantity Theory Equation
MV = p1q1 + p2q2 + p3q3 +...pnqn
where M is the quantity of money.
V is the velocity of the typical unit of money’s circulation.
pi is the price of some good that is consumed in the near future.
qi is the quantity of a specific consumer good.
n designates the total amount of each specific consumer good.

61. The Concept Of The Velocity Of Circulation (1)
Reminder of money in circulation: money that is capable of being spent. It consists of currency plus transferrable deposits that is not held in reserve by banks.
Velocity of circulation of money: the number of times the typical piece of money in circulation makes a circuit from consumers to producers who use the money to produce goods or resources and back to consumers again.
An example: A consumer buys from a retailer, who buys from a wholesaler, who buys from a producer, who pays an employee who plans to consume. This is one circuit.

62. The Concept Of The Velocity Of Circulation (2)
Not all pieces that are in circulation change hands: the coins in a piggy bank.
Some pieces circulate more than average.
Economists do not actually try to measure the velocity of circulation.
To measure it accurately, they would have to track each piece of money in circulation.
Because economists do not try to measure velocity, the quantity theory equation is a theoretical idea.

63. The Quantity Theory As A Theoretical Idea
As a theoretical idea, the quantity equation is mainly used to express the relationship between the quantity of money and average prices.
Accordingly, it is used in abbreviated form.
Where Q is real output.
P is the price level.
The dash over the V indicates that this variable is constant.

64. Real Output And The Price Level
Real output: the mix of different consumer goods produced and consumed during a given period of time.
Not easy to measure.
Price level: an average of absolute consumer goods prices.
Used to compare total price of a bundle of goods purchased by the typical consumer at the beginning of a period with the total price at the end of the period.
PQ is often called money output.

65. Two Simple Uses Of The Quantity Theory
Representing the effects of an increase in the quantity of money on the price level.
Representing the effects of a technological advance on real output.

66. First Simple Use Of The Quantity Theory: More Money Raises Prices
A 10% rise in the quantity of money will be accompanied by a 10% rise in the price level.
A 20% fall in the quantity of money is accompanied by a 20% decrease in the price level in a similar fashion.
Assumptions: velocity is constant; the increase in money does not change real output.

67. Second Simple Use Of The Quantity Theory: A Technological Advance Reduces Prices
A 10% increase in real output causes a 10% decrease in the price level.
Assumptions there is no change in the quantity of money or in its velocity.

68. The Artificial Nature Of The Examples
The events represented by these examples have no economic significance until we add statements about how actors in the market economy would act.
The theory of the business cycle helps us add some meaning to the quantity theory of money.

69. New Topic: Introductory Monetary Theory Of The Business Cycle The Nature of a Cycle (Figure 11-2)

70. Business Cycle Terms (1)
Expansion phase: one of two phases of a business cycle during which business activity is increasing.
Contraction phase: one of two phases of a business cycle during which business activity is decreasing.
Peak of a business cycle: the turning point at which the expansion phase turns to the contraction phase.

71. Business Cycle Terms (2)
Trough of a business cycle: the turning point at which the contraction phase turns to the expansion phase.
Amplitude of a cycle: a measure of the height of the peak and the depth of the trough.
Periodicity of a cycle: the length of time it takes for a cycle to occur.

72. Cycles In Nature 1. Night and day. 2. The seasons of the year.
3. The cycle of the moon and ocean tides.
4. Sunspots – flares from the sun every ten years.
5. El Niño – warming of the Pacific ocean every three to seven years.

73. A Monetary Theory – The Expansion Phase (1)
1. The central bank increases quantity of money by reducing the interest rate (discount rate) that it charges banks on loans.
Recall that the usual way that the central bank increases the quantity of money is to buy government bonds with new currency.
2. Entrepreneurs borrow the money from banks to finance new production and investment [Assume that entrepreneurs do not anticipate a cycle].
The lower interest rate reduces the costs of expanding production, investing in product improvement, and conducting cost-cutting experiments.

74. A Monetary Theory – The Expansion Phase (2)
3. Employers bid up wages and other resource prices. Employment increases as people join the work force.
4. Workers and other resource suppliers receive the additional income and spend it on consumer goods. Demands for practically all consumer goods rise. So do savings.
5. Retailers and others in the supply chain raise their prices.
6. Most people are optimistic about future profits.
7. Optimism leads lenders to inadequately investigate the creditworthiness of borrowers.

75. Comment On The Expansion Phase
What causes business activity to rise?
The increase in the size of the work force and the formation of new businesses by people who previously were not in business or in the work force.

76. Transition To The Contraction Phase (1)
Two causes of the transition to the contraction phase:
1. Resource suppliers, especially workers, realize that their real income is lower than their money income. So they demand higher pay. Some drop out of the work force.
Workers have a money illusion.
Money illusion: the mistaken belief during a period when the quantity of money is increasing that an increase in money income is also an increase in real income.
2. Savers and banks realize that making risky loans is unwise. They become more conservative.

77. Transition To The Contraction Phase (2)
Producers face rising costs in two ways:
1. Workers and other resource suppliers demand higher pay to remain employed in their jobs.
2. Savers and bankers require higher interest rates.
Some producers may go bankrupt.
Others begin to consider reducing or stopping their new investments.
Optimism begins to fade.

78. The Contraction Phase (1)
1. The higher costs of resources and the higher costs of loans squeeze producers.
2. Pessimism replaces optimism.
A. Producers reduce the production of goods and, at the same time, their demands for resources, including work. Some producers go bankrupt. The result is unemployment. Q (real output) falls.
B. Some savers and banks decide not to lend. Savers do not let their currency circulate. They hoard.
Velocity falls because individuals hoard instead of making what they regard as risky loans. They do not trust banks.
The quantity of money may fall if banks decide to keep excess reserves.

79. The Contraction Phase (2)
3. Consumer demand falls, causing a further squeeze on profit. The price level falls below what it will be in the longer run.

80. End Of The Cycle
Resource prices, especially wages, fall as resource owners bid for employment.
Entrepreneurs become less pessimistic and begin to hire resources to produce goods.
Business confidence rises.
Savers and banks begin to lend again.
An expansion begins until a settling level of business activity is reached – if there is no further increase in the quantity of money.

81. The Cycle From The Viewpoint Of The Quantity Theory Of Money
Suppose that the fall in real output completely offsets the rise. Then the increase in money would only cause an increase in prices.
A possible demonstration of the effects using the quantity theory of money equation.

82. Other Business Cycle Terms
Recession: the contraction phase of the business cycle.
Depression: an unusually long and/or deep recession.
Recovery: the part of the business cycle that occurs after the trough.
Stagflation is a term that was invented in the 1970s to refer to a situation in which prices are rising and substantial unemployment is recorded by statisticians.

83. Picture Of A Business Cycle While The Economy Is Growing (Figure 11-3)

84. Conclusion: Why Not Increase The Quantity Of Money?
The quantity independence characteristic of money tells us that money provides the same service no matter how much there is.
Why not increase its quantity?
If the central bank increases the quantity of money, it may cause a business cycle.
It cannot be a good thing if an increase in the quantity of money causes people to make errors in their decisions.

85. Appendix: An Innovation Theory Of The Business Cycle
This is the theory that a major innovation can lead to a business cycle.
Before we discuss the cycle, let us look at a case in which an innovation does not cause a cycle.

86. Effects Of An Innovation Without A Cycle
After the innovation, competition causes the producers of the innovated product to reduce price.
As a result, real output rises and the average level of prices falls. In the quantity theory of money equation:
_ _ 98
MV = PQ

87. The Innovation Theory Of The Business Cycle (1)
1. A major innovation occurs.
2. Businesspeople and lenders become over-optimistic and cause too many resources to shift into the industries affected by the innovation. The expansion phase begins.

88. An Innovation Theory Of The Business Cycle (2)
3. As entrepreneurs find that they cannot sell all of the goods they have produced, they lay off workers and reduce their demands for other resources. The result is unemployment. Their over-optimism turns to over-pessimism. The price level and real output fall below their long run level.
4. The contraction phase eventually ends as entrepreneurs form more realistic expectations about which lines of business are profitable.

89. An Innovation Theory Of The Business Cycle (3)
5. The amplitude of the cycle may be greater if:
A. The quantity of money is flexible.
B. Finance agents are able to persuade suppliers of resources to accept promises of future income for their services instead of current income. In other words, they persuade the resource suppliers to increase their saving.
Finance agent: a person who specializes in persuading suppliers of resources to accept promises of future income in exchange for their resources.

90. Appendix to Conclusion
An innovation can result in a business cycle if it leads to over-optimism.
The innovation results in malinvestment because it leads to unrealistic expectations.