Economics II: Labor and Income; GDP, Growth, Unemployment, Inflation; Money, the Fed, Exchange Rates, Fiscal Policy

This is Unit Fourteen of Social Sciences and History, part two of two: economics from inflation's winners and losers to fiscal policy's toolkit. Part one closed on what a measure excludes and what it divides by. This part turns to policy, and it carries one question through money, the Fed, exchange rates and the budget: which way does money move. A bond purchase adds reserves and loosens; a sale drains them and tightens. A currency that buys more has appreciated, and the other has necessarily depreciated. Spending above receipts is a deficit, and the running total is the debt. Ask the direction, and every policy item sorts itself, while the anchor's judgments about whether the policy works stay the anchor's, attributed, down to the capstone. By the end you will be able to say who inflation hurts and helps. To work the money multiplier and read a T-account. To read a Fed move for tool and direction. To say what moves an exchange rate. And to sort a tax and name fiscal policy's three lags.

Two entries on inflation's effects: who it hurts and helps, and how indexing follows it without preventing it.

Winners and losers.

SSH 1325 Who Inflation Hurts and Helps

Unexpected inflation hurts those whose wages and interest payments do not rise with it, a fixed pension, and helps those who owe money they can repay in cheaper dollars, a fixed mortgage. Low inflation matters little short-term but complicates long-term planning; high inflation muddles price signals. Hyperinflation often follows a shift to markets, the anchor notes.

Indexing.

SSH 1326 Indexing: COLAs, ARMs, Brackets

A payment is indexed if it is adjusted automatically for inflation. Private examples: wage contracts with cost-of-living adjustments, and adjustable-rate mortgages, whose interest rate moves with market rates. Public examples: tax brackets, which move so a raise is not a tax increase, and Social Security payments. Indexing follows inflation; it does not prevent it.

Five entries on money and banks: money's functions, M1 and M2, the T-account, the multiplier worked from the reserve ratio, and the defenses against a run.

Money's functions.

SSH 1327 Four Functions of Money; Commodity and Fiat

Without money people barter, needing a double coincidence of wants. Money serves four functions: medium of exchange, unit of account, store of value, and standard of deferred payment. Commodity money has value from another use, gold coins; fiat money has no intrinsic value but is declared legal tender, paper dollars. Commodity-backed currency is paper redeemable in the commodity.

M1 and M2.

SSH 1328 M1 and M2

M1 includes currency and money in checking accounts, demand deposits. M2 includes all of M1 plus savings deposits, time deposits, and money market funds: cash and checking, then savings, CDs and money funds. The glossary already puts savings accounts in M1, as the Federal Reserve did in May twenty twenty. The summary's split is taught, and the redefinition is recorded.

The bank's books.

SSH 1329 The Bank's T-Account

Banks are financial intermediaries between savers and borrowers. A balance sheet, or T-account, lists assets and liabilities: a bank's liabilities are its deposits; its assets are its loans, bonds, and reserves, which it does not lend. Net worth is assets minus liabilities, and defaults or a time mismatch can sink it. Diversifying and holding reserves reduce the risk.

The multiplier.

SSH 1330 The Money Multiplier: Working the Reserve Ratio

The exam gives a reserve ratio or a deposit and asks how much money the banking system can create, and the anchor's formula answers. The money multiplier is the quantity of money the banking system can generate from each dollar of reserves, equal to one divided by the reserve ratio, where the reserve ratio is the fraction of deposits a bank wishes to hold as reserves. Money is created when a bank lends part of a deposit, the borrower's payment is deposited in another bank, that bank lends part again, and so on; the sum of the deposits is the original deposit times the multiplier. The process assumes banks hold only limited reserves and lend the rest; in an ample-reserves world the chain is shorter. A reserve ratio of ten percent: the multiplier is ten. A new deposit of one thousand: the system can create up to ten thousand in deposits. A ratio of twenty percent: the multiplier is five. Banks choosing to hold excess reserves: the actual multiplier is smaller than the formula. Ask what fraction is kept, then invert it. The trap is multiplying the loan rather than the deposit; the chain begins with the whole deposit. The second trap is treating the formula as a law; it is a maximum that holds only when banks lend all they can.

Regulation.

SSH 1331 Runs, Insurance, Supervision, Last Resort

A bank run is depositors racing to withdraw on rumors of negative net worth, and many banks failing together can deepen a recession. Three defenses: deposit insurance, the FDIC guaranteeing deposits to two hundred fifty thousand dollars; bank supervision by four agencies; and the central bank as lender of last resort. The insurance limit is a current statutory figure.

Four entries on the Fed: three traditional tools and the ample-reserves regime, loose against tight, the pitfalls, and reading a policy move for tool and direction.

The tools.

SSH 1332 Three Traditional Tools and the IORB Regime

With limited reserves a central bank has three traditional tools: open market operations, buying and selling government bonds, the most used; reserve requirements; and the discount rate, its loan rate to banks. With ample reserves, the FOMC's main tool is the interest rate on reserve balances, and the federal funds rate is overnight bank-to-bank lending. Older sheets may expect open market operations.

Direction.

SSH 1333 Loose Against Tight; Quantitative Easing

Expansionary, or loose, monetary policy raises money and credit and lowers interest rates, boosting aggregate demand against recession. Contractionary, or tight, policy reduces money and credit and raises rates to hold down inflation; both are countercyclical, moving against the cycle. In the two thousand eight to nine recession central banks also used quantitative easing. Unit fifteen carries aggregate demand.

The pitfalls.

SSH 1334 Lags, Excess Reserves, Velocity: MV = PQ

Monetary policy is imprecise: effects arrive after long and variable lags; banks holding excess reserves cannot be forced to lend; and velocity, nominal GDP over the money supply, may shift unpredictably. The quantity equation: money times velocity equals price level times real output. Inflation targeting is the ECB's rule; the Fed chooses. Falling velocity blunts more money.

Reading a policy move.

SSH 1335 Which Tool, Which Direction? Reading a Policy Move

The exam describes a central bank action and asks its tool and its direction, and the anchor's chapter sorts both. Tools, in the limited-reserves regime: open market operations, buying bonds to add reserves and lower rates, selling to drain them; reserve requirements, lowered to free reserves, raised to lock them; the discount rate, cut to encourage borrowing from the Fed, raised to discourage it. In the ample-reserves regime: the interest rate on reserve balances, lowered to push banks toward lending, raised to make holding reserves pay. Direction: any action that raises money and credit and lowers rates is expansionary, or loose; any that reduces them and raises rates is contractionary, or tight. The exam may ask the main tool; the traditional answer is open market operations, the anchor's current answer the interest rate on reserve balances. The Fed buys Treasury bonds: open market operations, expansionary. The reserve requirement rises: contractionary. The discount rate is cut: expansionary. IORB is raised: contractionary, in the ample-reserves regime. Quantitative easing, purchases of long-term securities: expansionary. Ask two questions: what did the bank touch, and which way did money move. The trap is the direction of a bond sale; selling bonds pulls reserves in, so it tightens. The second trap is the main-tool question, where the regime the question assumes decides the answer, and the course names both. Which way money moved: the lecture's question, as a procedure.

Three entries on exchange rates: appreciation and depreciation, four horizons, and four regimes.

Appreciation and depreciation.

SSH 1336 Appreciation and Depreciation Are Symmetric

Dollars are demanded by exporters, foreign tourists and foreign investors; supplied by importers, U.S. tourists abroad and U.S. investors going out. When currency A buys more of B, A has appreciated, or strengthened, and B has depreciated, or weakened. A stronger currency helps buyers and hurts sellers; a weaker dollar helps exporters and hurts importers.

Four horizons.

SSH 1337 Speculation, Returns, Inflation, PPP: Four Horizons

In the extreme short run, speculation, self-fulfilling for a time. In the short run, rates of return: high real rates strengthen a currency. In the medium run, inflation: high-inflation countries see depreciation. Over many years, purchasing power parity, equal prices for traded goods. Minutes, months, years, decades. Central banks watch the rate for trade, banks and capital flows.

The policies.

SSH 1338 Float, Soft Peg, Hard Peg, Merged

A floating rate lets the market decide, freeing monetary policy, risking abrupt moves. A soft peg lets the market decide with occasional intervention, by rates or by buying the currency. A hard peg fixes the rate and ties monetary policy to defending it. A merged currency gives up national monetary policy. Tobin taxes on capital flows are the anchor's aside.

Two entries to close: sorting taxes and budget positions, and fiscal policy's toolkit with its three lags and crowding out, the anchor's judgments attributed.

Sorting the taxes.

SSH 1339 Deficit, Surplus, Debt; Progressive, Proportional, Regressive: Sorting the Taxes

The exam names a tax or a budget position and asks its type, and the anchor's chapter supplies the terms. A budget deficit is spending above tax receipts in a year; a surplus, receipts above spending; a balanced budget, equal; the national debt is the accumulated sum of past deficits and surpluses. A progressive tax takes a greater share of income from higher incomes, the federal income tax; a proportional tax a flat share regardless of income, the Medicare payroll tax; a regressive tax a smaller share from higher incomes, the Social Security payroll tax above its threshold. The marginal tax rate is the rate on the next dollar of income: the anchor's example taxes income in brackets and calls a single filer at thirty-five thousand a fifteen percent marginal taxpayer. Everyone paying two point nine percent of wages: proportional. Rates climbing from ten to thirty-five percent by bracket: progressive. Wages above a cap untaxed: regressive above the cap. This year's shortfall: deficit; the running total: debt. The trap is the anchor's own definition of marginal tax rate as the tax on all yearly income, which describes a total; its example shows the bracket rate, and the course records the error. The second trap is calling the payroll tax one thing; its two halves fall in two categories.

Fiscal policy's toolkit.

SSH 1340 Fiscal Policy's Toolkit and Its Three Lags: Stabilizers, Discretion, Crowding Out

The exam's fiscal-policy item asks what government can do with spending and taxes, when, and why economists doubt it, and the anchor's chapter answers in that order, with its judgments kept its own. What: fiscal policy is federal spending, taxation and borrowing; in recent decades federal spending and taxes have run about eighteen to twenty-two percent of GDP, and defense, Social Security, healthcare and interest take about seventy percent of the federal total, the anchor's dated figures. Expansionary fiscal policy raises aggregate demand by more spending or lower taxes and fits an economy in recession below potential GDP; contractionary policy cuts demand by less spending or higher taxes and fits an economy above potential. When: some of it is automatic. Automatic stabilizers are tax and spending rules that soften a slowdown and restrain a boom without new legislation, since tax receipts fall and benefits rise on their own in a recession; the standardized employment budget shows what the deficit would have been at potential GDP, separating the stabilizers' work from discretionary policy, a new law changing taxes or spending on purpose. Why the doubt: discretionary policy must be recognized, legislated and implemented, three lags that can land the stimulus after the recession has ended; government borrowing can raise interest rates and crowd out private investment; temporary and permanent changes act differently; and the process is political. Many economists, the anchor says, conclude that discretionary fiscal policy is a blunt instrument best kept for extreme situations, and it judges the merits of a balanced-budget amendment questionable, since flexibility for wars and recessions is worth keeping. The deficit record it gives is chronological: wartime debt paid down in peace for most of the twentieth century, peacetime debt in the eighties and early nineties, surpluses from nineteen ninety-eight to two thousand one, deficits since two thousand two, very large ones in two thousand eight and nine. The blunt-instrument and balanced-budget judgments are the anchor's, voiced as its own; the chronology names years and no administrations; every percentage is dated to the anchor's writing. Unit fifteen carries the Keynesian and neoclassical arguments behind the doubt. Which way money moves, and whose judgment says whether it should: the lecture's question, closed.

Look at what you can now do. You can say unexpected inflation hurts fixed incomes and helps fixed debts, and that indexing follows inflation without preventing it. You can name money's four functions, split M1 from M2, read a T-account with deposits as liabilities, and work the multiplier as one over the reserve ratio. You can read a Fed move by asking what it touched and which way money moved, and you give both answers to the main-tool question. You can say speculation, returns, inflation and purchasing power parity move a rate on four horizons, and name float, soft peg, hard peg and merged. And you can sort a tax by whether its share rises, stays flat or falls with income, and name recognition, legislation and implementation as fiscal policy's lags, with the anchor's doubts attributed. Which way money moves was the question, and it ran to the end. Unit fifteen opens on trade.