Boom and Bust Economy in either boom or bust. ▫Boom = prices rising (inflation). ▫Bust = recession/depression (high unemployment). Keynesian. ▫In boom, government increase taxes. ▫In bust, government increase spending. But what to do if inflation AND high unemployment?
Inflation Prices rising. NOT required. War against inflation? ▫Greedy businessmen increase prices to increase profits (greed). But why not increase prices even more?
Price Amount of money the buyer is willing to spend. The interaction between the buyer and seller brings about the ruling price in the market. Supply and demand. ▫If supply increased, price lowers. ▫If demand increases, price rises.
Money Can Set Price If amount of money in the buyer’s possession increased by 20%, prices will rise 20%. Thus, the stock or supply of money increases prices. ▫NOT greed.
How is Money Created? Arises on the market as individual begin to choose commodities to act as money. ▫The best: High demand, durable, long storage, mobile, easily recognizable, readily divisible without losing value. ▫Historically, gold and silver.
Gold Standard When a society or state adopts a certain commodity as money and is used daily it adopts a commodity standard. Natural course is gold or silver standard. Supply of gold determined by the market: ▫Technological conditions of supply; ▫The price of other commodities.
Why Would State Want Control Over Money Supply? Alternative to taxation. So, it acquired the monopoly power to counterfeit. ▫Result = fiat paper standard. Dollar is piece of paper with names stamped on them issued by the State. ▫Result = inflation.
Political Problems with Inflation Too visible. ▫Fear of the public finding out and taking power away. So, created Federal Reserve and fractional reserve banking system.
Federal Reserve Central bank for the US. Controls the entire commercial banking system. Permits commercial banks to pyramid deposits on top of the Fed’s own reserves. ▫6:1 ratio (1973). ▫NOW: Less than $12.4 million = none. $12.4-$79.5 million = 1/3:1 (3%). Over $79.5 million = 10:1.
Bank Deposits are Money? Constitutes a promise by a bank that it will redeem its demand deposits in cash (Federal Reserve Notes) anytime the depositholder (bank customer) may desire.
How Do Banks Create New Deposits? Banks receive $1 billion new reserves. Lend out $6 billion. ▫By creating new deposits (i.e. loans). But it’s NOT existing money that was deposited.
Open Market Purchases How the Fed determines the total reserves of the banks. Fed goes to open market and buys an asset. ▫Could be anything (mostly US government bonds). ▫Seller receives the note. ▫Seller takes note to bank. Fed NOT open to private individuals, only banks and federal government. ▫Seller gets note price in checking account. ▫Bank gets note price from Fed.
Federal Reserve System (cont.) Created in 1913. In 1933, US went off gold standard. ▫Removed the shackles. ▫Prior, the note was redeemable in gold. Fed can’t create gold. In 1971, US went off gold window. ▫Prior, gold standard still applied to foreign governments.
The Business Cycle Regularly recurring series of booms and bust. NOT required. ▫If boom in computers, bust in computers. ▫NOT overall economy. Why occur? ▫Industry’s fault; ▫Banking system’s fault.
Banking System’s Fault Fractional reserve banking = bank credit expansion. ▫Raises prices. ▫Artificially lowers rate of interest. Sends misleading signals to businessmen, causing them to make unsound investments (malinvestment).
Natural Rate of Interest Determined by time preferences of all buyers and sellers in economy. Loan. ▫Present good (money used now); ▫Exchanged for future good (payment later). People want money NOW. ▫NOT worth risk to wait. ▫Present goods contain premium over future goods. ▫Premium = interest rate.
Result of Decrease of Interest Rate Businessmen will invest in: ▫More capital goods; and Durable equipment, industrial raw material, construction. ▫Higher wages. Result, increased demand. ▫Labor costs increase. ▫Businesses think they can meet the costs.
Result of Decrease of Interest Rate (cont.) Workers spend higher wages. ▫On consumer goods NOT capital goods. ▫NOT saving. Result, depression in capital goods. ▫Businessmen shouldn’t have invested so much in capital goods. Proportions between consumption (consumer goods) and investment (capital goods) reestablish.