Monday, October 29, 2007

Info on Tues (10/30)

A number of students have called me to inquire about classes Tuesday night. I have called NCC and after talking to about 20 people I got information that there is some activities fair on Tues night that is causing classes to be cancelled during our time period. I was unaware of this (as apparently almost everyone else was), so our next class will be on Thurs. Quizzes will be due on Thursday.

Friday, October 26, 2007

Once you have your charter...

You probably want to join the Federal reserve system as a member bank.

Member Banks

The nation's banks can be divided into three types according to which governmental body charters them and whether or not they are members of the Federal Reserve System. Those chartered by the federal government (through the Office of the Comptroller of the Currency in the Department of the Treasury) are national banks, and by law are members of the System.
Banks chartered by the states are divided into those that are members of the System and those that are not. State-chartered banks are not required to join the System, but they may elect to become members if they meet the standards. As of June 30, 2006, there were a total of 7,480 commercial banks nationwide, of which 2,548 were members of the System. The Federal Deposit Insurance Corporation is responsible for supervising non-member banks.
Member banks must subscribe to stock in their regional Federal Reserve Bank in an amount equal to 3 percent of their capital and surplus. They receive a 6 percent annual dividend on their stock and may vote for Class A and Class B directors of the Reserve Bank. However the stock does not carry with it the control and financial interest that is normal for the common stock of a for-profit organization. It offers no opportunity for capital gain and may not be sold or pledged as collateral for loans. The stock is merely a legal obligation that goes along with membership.

How to start a bank

Click here to learn how to start your own bank.

(Note: this website should help you further understand how the banking system works).

Data and the Fed

The WSJ has a good summary of the latest economic data here. For the rare few without a subscription, here is what the article is saying.

The latest readings on the U.S. economy show continuing signs of weakness: Sales of newly built homes over the summer were weaker than previously estimated, September manufacturing was subdued, business inventories are mounting and the job market is displaying worrying signs of erosion.

How do we read this

1) Declining sales of newly built home suggest that construction of further new homes is unlikely to occur. This hurts GDP directly via a decline in residential investment within the GDP formula (C + I + G + NX). Further, since sales are slowing and inventory levels are high, prices are likely to come down and this can hurt GDP via consumption if people are no longer able to tap home equity to fund consumption

2) Rising business inventories suggest that businesses are not selling as many goods as they had anticipated. This points to a slowdown because they are unlikely to continue producing at current levels until inventories levels are back to where they want them

3) Although the latest NFP report suggests a decent labor market, data on "initial claims" has been rising as of late. Initial claims are initial unemployment claims people make when they lose their job so they can continue collecting unemployment.

How bad does this data look? Well, it certainly does not point to robust growth but the text of the article is not as bad as the first paragraph seems.

1) Sep new home sales rose a bit this month, with inventories declining modestly and pricing rising (editorial: although this is probably an illusion since the data is flawed in that it doesn't include cancelled contracts)

2) Business inventories were previously falling, so it may be the case that businesses are rebuilding their inventories back to the levels they want them at. Granted, this doesn't point to further build ups (which means no boost to GDP), but it "may" not mean a slowdown is in order. The strength in business investment suggests this is a possibility

3) Initial claims, while they are rising, are still not that high historically speaking and may be adversely impacted by the recent auto strikes, which temporarily boosted the claims.

How does the Fed respond to this? As you can see, the Fed has their work cut out for them since you can argue the imperfect data either way. However, it does look the downside risks to growth are real and potentially bad. Therefore, the current data is "bad enough" that another rate cut is likely as a hedge against a potential recession. As you will soon learn, monetary policy operates with a lag (between 6-18 months), before the full force of the rate cut can take place. If the recession risks are real, the Fed is going to want to get the rate cuts in the pipeline now because if they wait too long they will miss the recession (then again, on the other side of the coin, if no recession is coming the Fed can stoke inflation).

Now you know why they appoint these guys to 14 year terms.

Thursday, October 25, 2007

Fed meeting next week

This is just a reminder that there is a Fed meeting scheduled for Oct 30-31st (the 31st will be the decision). You can read a schedule of all the meetings, plus the previous statements and minutes, here.

The consensus looks to be another 25bps to 50bps rate cut. The predictions market is pricing in a 25bps rate cut with about a 70% chance, a 50bps cut chance has about a 20% chance.

Remember that the Fed is worried about the recession in the housing market spilling over into other sections, causing an economy wide recession. In order to prevent this, the Fed is ordering the New York desk to purchase US government securities, which will increase the supply of money and push the Fed funds rate down. The fed fund rate, in turn, is supposed to influence other interest rates down and stimulate economic activity in the short run.

First bank of the United States

You can read about our very first federa bank here and here

More info on the Fed

The Federal reserve board has a FAQ website that answers many of the questions posed in class. You can access the website here . Here are some answers:

Who owns the Federal Reserve?

The Federal Reserve System is not "owned" by anyone and is not a private, profit-making institution. Instead, it is an independent entity within the government, having both public purposes and private aspects.
As the nation's central bank, the Federal Reserve derives its authority from the U.S. Congress. It is considered an independent central bank because its decisions do not have to be ratified by the President or anyone else in the executive or legislative branch of government, it does not receive funding appropriated by Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms. However, the Federal Reserve is subject to oversight by Congress, which periodically reviews its activities and can alter its responsibilities by statute. Also, the Federal Reserve must work within the framework of the overall objectives of economic and financial policy established by the government. Therefore, the Federal Reserve can be more accurately described as "independent within the government."
The twelve regional Federal Reserve Banks, which were established by Congress as the operating arms of the nation's central banking system, are organized much like private corporations--possibly leading to some confusion about "ownership." For example, the Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company. The Reserve Banks are not operated for profit, and ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, 6 percent per year.

How is the Federal Reserve funded?

The Federal Reserve's income is derived primarily from the interest on U.S. government securities that it has acquired through open market operations. Other sources of income are the interest on foreign currency investments held by the System; fees received for services provided to depository institutions, such as check clearing, funds transfers, and automated clearinghouse operations; and interest on loans to depository institutions (the rate on which is the so-called discount rate). After paying its expenses, the Federal Reserve turns the rest of its earnings over to the U.S. Treasury.

Topic 7 - Money Creation and Deposit Insurance (Chapter 16)

I) A banks balance sheet
a) Assume only commercial banks exist to make things operate. A commercial bank operates by accepting deposits for checkings, savings, cds, etc and using that money to make loans. The bank makes a profit by charging a higher interest rate for the loans it lends than the interest rate it pays for deposits. So to understand the rest of this you need to get that the bank attracts deposits and makes its money by lending those deposits out.
b) The federal reserve requires the bank to hold part of these deposits at the Fed as reserve, in case people decide to show up to the bank one day and get their deposits back.
c) Required reserves - the amount of money the bank must hold as reserve at the Fed
d) excess reserves - any "extra" money the bank holds as reserve. (Total reserves = reserves - required reserves).
e) Deposits (called transactions deposits in the book, are the banks liabilities).
f) reserves and the loans the bank has are its assets.
g) Balance sheet accounting on page 397

II) Money creation
a) in the above example money was not created. It was merely transferred from one place to another. However, as you can see, fluctuations in the money supply can influence inflation. So how is money created?
b) The only institution that can increase or decrease the amount of money in an economy is the Fed.
c) Open market operations
1) Fed buys a US government security (creates 100,000 of reserves, and hence money). The bank buys the security and deposits the money in the bank's reserve account. Hence money supply goes up because this money never existed before
2) Fed sells a US government security (takes away 100,000 of reserves, and hence money). By selling a security the bank is giving the Fed money in exchange for the security.

III) Money multiplier
a) If the Fed buys a US security and creates $100,000 in money, the bank will turn around and lend that money out to an individual or a business. That person in turn will spend the money, creating more deposits at other banks and on and on. This is the entire purpose of the balance sheets on 401-403. The idea is that there is a ripple effect and we have another "multiplier," this time with money.
b) Money Multiplier = 1/(required reserve ratio)
c) This is the potential multiplier. In real life it may be reduced by the following forces
1) leakages

IV) Tools the federal reserve has to implement monetary policy
a) required reserve ratio
b) discount rate - interest rate the Federal reserve charges for reserves it lends to institutions
c) Fed funds rate* - interest rate banks charge to each other for reserves it lends out.

V) FDIC insurance to prevent bank failures

Topic 6 - Money and Banking (Chapter 15)

Class Notes - Money and Banking (Chapter 15)

I) The functions of money
a) medium of exchange
b) unit of accounting
c) store of value
d) the concept of liquidity (i.e. the ease of converting a house into cash vs having cash on hand).
e) what backs money? - fiduciary monetary system (i.e. trust that the government will maintain stability in money)

II) What is money?
a) monetary base - the bills and coins in your hand
b) m1 = monetary base + transactions deposits (checks and check cards) + traveler's checks
c) m2 = m1 + savings accounts + small denomination time deposits (i.e. cd's less than $100,000 in value) + money market mutual funds
d) the idea is that what we consider money is more than just cash on hand. That is, other assets, like savings account, are close enough to actual money that we should include it in our "broader" definition of money

III) Financial intermediation
a) why do we have banks?
1) asymmetric information - the borrower may have more information about his company than you do, which could lead to fraud if you do not investigate thoroughly. But this is time consuming
2) moral hazard - after the borrower has the money, he may take risks with it that he otherwise wouldn't take. Preventing this is very time consuming
3) big banks can often do things cheaper than people can individually
b) therefore, most people lend and borrow money indirectly via banks rather than lending to each other directly.

IV) Central Banks
a) Purpose
1) perform banking functions for their nations government
2) provide financial services for private banks
3) conduct monetary policy *

V) The US Federal Reserve
a) organization
Board of Governors - 7 full time members. The chair is the head official for both the BOG and the Fed. This is the role Greenspan had for many years. Currently Ben Bernanke is the "Fed chief"
b) 12 Fed district banks (with 25 branches). Each of the 12 district banks has a president.
3) FOMC (Federal open market committee) - BOG (7) + President of the NY Fed + 4 other presidents among the remaining district banks. These 4 voters rotate annually.


Monday, October 22, 2007

Macroeconomics - Quiz 6

EC207 – Intro The MacroEconomics
Quiz 6
Professor Matthew Festa
The Keynesian Cross Graph and the multiplier
Due on Thurs Oct 25th. I will penalize if late

1) Draw the Keynesian Cross. Note where expenditures and production are on the x and y axis. Then Draw actual expenditure and then planned expenditure curves on the graph. Where is equilibrium and why? ( 3 points)

2) Write the consumption function and explain the components of it ( 2 points)

3) Explain the rationale behind autonomous consumption? How and why would consumption take place at this level? (1 point)

4) If the Marginal Propensity to consumer is 0.8, what is the multiplier? If The government increases spending by $2 million, how much will output increase. If they also cut taxes, how much will output increase? (3 points)

5) Show how this effect will look on the Keynesian Cross Curve. (1 point).

Thursday, October 18, 2007

Macroeconomics Quiz 5

Macroeconomics Quiz 5 - Aggregate Supply and demand
Professor Matthew Festa
Due in Class Tuesday Oct 23rd.

1) (2 points) - Draw the long run aggregate supply curve and explain the economic reason why it is shaped the way it is. Use the principles of Say's law in your explanation.

2) (2 points) Draw the "Keynesian" supply curve and explain why it is shaped the way it is. Explain how this differs from Say's law in the first example.

3) (2 points) Explain the three economic reasons why the aggregate demand curve slopes the way it does (draw it to illustrate your point.

4) (2 points) If the government or federal reserve stimulates the economy in such a way that the aggregate demand curve shifts right (i.e. increases), what will happen to the price and output level if we have a classical economy? Why?

5) (2 points) What will happen in a Keynesian economy? Why?

Thursday, October 11, 2007

No class tonight

I apologize for the lateness of this notice, but it is impossible to hold class tonight due to the roads. I called the college to see if they were going to cancel class and they said no. I argued with them that it was a bad idea to no avail, so I tried to make it anyway just in case there were some people who were somehow able to make it. However, the road conditions by me were so bad that I wouldn't have even gotten there until after class ended anyway (and I left very early).

Obviously, I was expecting many people not to come. But there may be some people who were able to make it and to them I apologize. I will be speaking to those responsible for allowing the school to remain open in these conditions tomorrow.

Topic 5 - Aggregate Supply/Demand and fiscal policy

Parts of Chapters 10-12

I) Output in the long run
a) long run aggregate supply curve
b) why it is vertical - read this
c) shifts in the long run supply curve

II) Aggregate Demand Curve
a) The total of all planned expenditures in the economy
b) why it is downward sloping
i) real money balance effect
ii) interest rate effect
iii) exchange rate effect - note: for more on these three, read here.

(This takes us to page 246 in the book). Now we will go to Chapter 11

III) Classicals vs Keynesians
a) Say's law and the vertical long run supply curve - read here
b) Why do the classicals believe this?
c) Keyes and the horizontal supply curve
d) Keynes arguments against the classicals

(This ends at page 270 in Chapter 11)

(Chapter 12)

IV) The Keynesian Cross.
a) Read here for more . I personally believe the books explanation is long winded. You may agree or disagree with me. However, I do recommend taking a look at the web page I provided as an alternative way of understanding this graph
b) The keynesian cross works if we assume that the price level is fixed (the supply curve is horizontal).
c) consumption function y = c0 + mpc(y-t)
co = autonomous consumption
mpc = marginal propensity to consumer
y = income
t = taxes
d) the multiplier effect (page 305) 1/(1-MPC)
e) The multiplier effect argues that spending more money via either tax cuts or government spending increases spending by more than the actual amount spent. The argument is like dropping a pebble in water and having the ripple effect be bigger than the actual pebble. If you give someone a $100 and he spends it, the money goes to someone else who spends it, and then that person spends it, etc. etc.

Aggregate Supply/Demand Model

The aggregate supply and demand model is the model you need to know cold in macroeconomics. It is the model you will use to judge the effects of fiscal and monetary policy in both the short and long run. Let's talk first about aggregate demand and then aggregate supply

Aggregate demand -

The aggregate demand curve looks a lot like your normal demand curve in that it is downward sloping, the lower the price the more aggregate demand. However, the reasoning for the downward slope is different. There are three reasons for the downward sloping demand curve and I cannot explain them better than this website. (You can ignore the part from IS/LM on down. That is intermediate macroeconomics).

Aggregate supply -

There are two supply curves. The first is the long run aggregate supply curve, which you can read about here. In the long run the supply curve is vertical because the price level cannot effect output in the long run. Output in the long run is solely a function of labor, capital and productivity. Inflation (price increases) do not increase supply in the long run because workers will demand higher wages, decreasing the extra profits businesses can make and removing the incentive to boost output given the economies productive capacity.

Short run - The problem is that in the short run prices and wages may not adjust quickly. In fact, the economist John Maynard Keynes argued that in the short run the supply curve was horizontal (flat) because prices did not change at all.

These two radically differing views on the supply curve are the key division between classical and keynesian economists.

Why do Classicals believe the supply curve is vertical in the long run -

Say's law - a common (partially wrong) interpretation of this law is that supply creates its own demand. A more reasonable statement of the law is that wages and prices are flexible enough to ensure production is always at its potential, never more nor less. How? Well if you supply goods to the market you pay wages and you generate income. This income is then used to purchase the products you produced. What if people do not spend but instead save? Well then the increased savings lowers interest rates and this boosts investment. So savings is a case where you shift production from consumption to investment. What if demand for the product falls? Then they cut prices. What if the wages are still too high? Businesses will cut wages in order to prevent unemployment.

Therefore, the market itself will adjust via prices, wages and interest rates to ensure that there are no recessions.

Keynesian supply curve - the problem for this view was the great depression. During the great depression prices were sticky (did not change), wages did not fall, and low interest rate did not generate more investment. This suggested that the market was not correcting itself, at least not fast enough. Because of this Keynes argued against the classical's by saying "in the long run, we're all dead."

Wage stickiness is the easiest to understand because oftentimes workers, especially in unions, do not want to accept nominal wage reductions.

Price stickiness is often explained using the example of menu costs. Menu's cost money to print and restaurants do not like reprinting menu's every day cause its inefficient. But what is efficient for one business is inefficent for the economy as a whole. Other reasons for price stickiness is imperfect competition, where a cut in prices does not immediately translate into higher sales (thus it is not undertaken). Businesses sometimes wait for someone else to lower their prices before they do, etc. etc.

Interest rates falling was a phenomonen in the Great Depression. When we get the monetary policy, we will see that the belief that lower interest rates did not stimulate investment and consumption was the major reason why Keynes argued against monetary policy as a tool to fight against recession. But the way interest rates could fail to stimulate the economy is via a liquidity trap. You can read about it here. but

liquidity trap occurs when the economy is stagnant, the nominal interest rate is close or equal to zero, and the monetary authority is unable to stimulate the economy with traditional monetary policy tools. In this kind of situation, people do not expect high returns on physical or financial investments, so they keep assets in short-term cash bank accounts or hoards rather than making long-term investments. This makes the recession even more severe

So who is right?

If the classicals are right, using fiscal or monetary policy to stimulate the economy will lead only to higher prices, not to higher output. If Keynes is right then using fiscal and (although he didn't believe this) monetary policy will stimulate the economy but not prices (note to fellow economists: I am assuming a hyper-keynesian case in order to demonstrate the theory).

After much debate, the mainstream view is now that fiscal and monetary policies will do both in the short term (that is, boost growth and prices), but in the long term the economy operates the way the classicals assume it does. So when we put the model together we will graph a vertical aggregate supply curve for the long run and an upward sloping aggregate supply curve for the short run.

Then we can analyze the effect of the policies you hear about in the newspaper and on TV.

Keynesian Cross

The Keynesian cross is going to be the model we use to study how fiscal policy can be used to counter a recession. This website gives a much simpler explanation than the book does, so I advise you check it out.

Also, if you want to see a good graph of the Keynesian cross, click here.

Monday, October 08, 2007

Note on price controls.

This is in the notes but I want to remind you to focus on price controls, both price ceilings and floors.

Remember that a price ceiling is a maximum price that a market is allowed to charge. If set below the equilibrium rate, this will lead to a permanent shortage

A price floor is the lowest price a market can charge. It set above the market price then a permanent surplus will result. Here the government usually buys all the extra goods up and stores it somewhere to rot away.

The easy economic solution is to remove the price control. However, oftentimes this proves to be tough politically (witness price controls in the agriculture industry).

Sunday, October 07, 2007

Outline for Chapter 9 - Long run economic growth

I) Economic growth
a) definition - occurs when there are increases in per capita real GDP, measured by the rate of change in per capita real GDP per year.
b) the limitation of economic growth is that it says nothing about the distribution of economic growth, only whether the overall economy is growing.

II) What causes economic growth
a) increases in labor - this is true for real gdp, but not for per capita real GDP, since the extra output is merely be shared among more people
b) savings - the more savings, the more money for investment in new machinery and equipment
c) productivity
i) measured by dividing total real GDP by the number of workers
ii) productivity increases when you can get more real GDP with the same #of workers

III) productivity and technology
a) new technology for workers is the way you get more productivity. New Growth theory tells us how economies develop these new technologies.
i) greater rewards for technology acts as an incentive to innovate
ii) innovation - more broad than simply inventing. Innovating takes a new invention and applies it to the economy (i.e. the innovators in the computer industry. examples Bill Gates and Steve Jobs)

b) This points to the importance of institutions and human capital
i) institutions - private property, effective government.
ii) human capital - a knowledgeable workforce.
iii) patents - government protection that gives an innovator the exclusive right to make, use or sell an invention for a limited period of time (currently, 20 years).

Saturday, October 06, 2007

Quiz 4 answers

Click here for the quiz questions .


1) B
2) C
3) D
4) B
5) A
6) C
7) C
8) A
9) A
10) D
11) B
12) C
13) D
14) A

Answer to GDP question in Q3

Click here for the problem:


Nominal GDP for 1997

100 spears * $1 = $100
200 Horses *$2 = $400

Nominal GDP for 1997 = $500

Nominal GDP for 1998

200 spears * $2 = $400
300 horses * $3 = $900

Nominal GDP for 1998 = $1300

To calculate the change => (1300-500)/500 = 1.6 * 100 = 160%

For Real GDP I asked you to use 1998 prices, so we have to change 1997 to 1998 prices. We can do this by multiplying the output in 1997 by the prices in 1998

100 spears * $2 = $200
200 Horses *$3 = $600

Real GDP for 1997 = $800

Since we asked for 1998 prices, no correction has to be done for 1998. That is, nominal GDP for the base year (the year we are using as the price level) is equal to real GDP

To calculate the change:

(1300-800)/800 = 0.625 *100 = 62.5%

*Note = Some people you used 1997 prices may have gotten a slightly different answer. This is a problem inherent to this method, which is why the government uses a more complicated method. But the principle is the same and that is what we are interested in.