Money, Banking, and Financial Markets

A Modern Introduction to Macroeconomics

Dale K. Cline, Sandeep Mazumder

• Éditeur: Routledge
• Année: 2022
• ISBN:
  9781000552645
• Édition: 1
• Sujet: Economics
• Sous-sujet: Banks & Banking

This innovative text offers an introduction to money, banking, and financial markets, with a special emphasis on the importance of confidence and trust in the macroeconomic system. It also presents the theory of endogenous money creation, in contrast to the standard money multiplier and fractional reserve explanation found in other textbooks. The U.S. economy and financial institutions are used to explain the theoretical and practical framework, with international examples weaved in throughout the text. It covers key topics including monetary policy, fiscal policy, accounting principles, credit creation, central banks, and government treasuries. Additionally, the book considers the international economy, including exchange rates, the Eurozone, Chinese monetary policy, and reserve currencies. Taking a broad look at the financial system, it also looks at banking regulation, cryptocurrencies, real estate, and the oil and gold commodity markets. Students are supported with chapter objectives, key terms, and problems. A test bank is available for instructors. This is an accessible introductory textbook for courses on money and banking, macroeconomics, monetary policy, and financial markets.

Part I How the economy works Nuts and bolts

DOI: 10.4324/9781003251453-2

Leonardo da Vinci once said, “The noblest pleasure is the joy of understanding.” It is with the goal of gaining greater understanding that we venture into the world of macroeconomics. Much like painting a landscape, we will begin with the basic framework and then add subject matter, one layer at a time, which will gradually build in the foreground, the horizon, the sky, and all the other details that complete the picture.

The economy is an ever-changing animal. If macroeconomic outcomes were completely predictable, it would be simple for economists to develop prescribed formulas to handle any situation. Because the economy is a function of human circumstances, there are no universal formulas to provide systematic solutions for each and every scenario that comes about. So, any study of the economy must consider the actions of people. That certainly adds a layer of unpredictability!

Much like politics, we all have different experiences and outlooks that color the way we view the economy. But the universal truths remain constant. There are basic facts that apply to any study of the economy and these facts provide the foundation upon which the following chapters are built. Adding individual interpretation to the facts allows each of us to apply our understanding in our daily decision making. And while we might each see things a bit differently, if we understand the universal truths, we will make better decisions.

This will not be an arduous journey. The chapters are presented in a way that will gradually introduce topics and provide background without belaboring the point. Think of it as a stroll down a meandering road. We will stop off at a few points along the way. We may spend more time at certain stops than at others and we will see new things as we go. But when we reach our destination, we will have gained new understanding. Hopefully, we will have enjoyed the scenery along the way.

1 Confidence, monetary policy, and fiscal policy

DOI: 10.4324/9781003251453-3

Objectives

1. To understand the basic premise of monetary policy, fiscal policy, and how both interact with confidence in the economy.
2. To learn how GDP is calculated.
3. To study an example of government taxation and the implications it has for the economy.

Suppose it is a beautiful spring day and you are standing in your yard, admiring your well-cut lawn. You could stand there and admire the whole lawn all at once, or you could pull out a single blade of grass and then examine it in fine detail using a high-powered microscope back in your lab. In a similar way, we can apply this logic to the economy: one can look at the economy as a whole, known as macroeconomics, or you can zoom in on particular markets or industries, which would be microeconomics. For the purposes of this book, we are talking about the economy from the macroeconomic perspective.

One can visualize the economy on a macroscale sitting upon three pillars: confidence, monetary policy, and fiscal policy. Those are probably not the first terms that come to mind when you think about economics, but they are essential components of understanding how the economy works at a macroeconomic level. A healthy economy cannot exist without these three pillars standing strong, supporting and reinforcing each other. Each plays an individual role but all of them must be present and working together to optimize economic growth, stabilize inflation, and fight unemployment. Improvements in productivity, innovation, and technology all rest upon the foundation of these three pillars that form the bedrock of the national economy.

Confidence

Of the three pillars, confidence is paramount. Such a simple word. Yet, it may be the most important ingredient for a nation’s economic well-being. The other two elements cannot compensate for a lack of confidence and, without it, the economy cannot prosper. The 2020 COVID-19 pandemic-induced recession is an example of this: monetary policy and fiscal policy had a tough time fighting this recession because confidence was so low. Why is confidence so important? It sets the tone for everything else, infusing a positive spirit that inspires the ability to overcome seemingly insurmountable odds. A sense of confidence fuels business innovation and encourages employers to hire young and exciting talent. It also gives us the momentum to go out and spend our money in the economy. Confidence is important for us at the individual level, as well as for policymakers at the national level.

Confidence is particularly crucial when we face adversity. Apple Inc—one of the most famous companies in the world—was at one time a business on the decline. 1997 marked the 12th consecutive year of financial losses for the company, which prompted them to bring co-founder Steve Jobs back to the firm. Jobs came in and announced a large partnership with rival company Microsoft, which injected much-needed investment into the company. History now tells us of the amazing innovations that Apple has since implemented, propelling them into being one of the most iconic brands on earth. Lego is another great example of a company that has overcome adversity: their toys are now ubiquitous all over the world, but this was not always the case. In 2004, the company had a loss of $174 million and was on the brink of bankruptcy. That same year, Jorgen Vig Knudstrop became the CEO and immediately altered the business, including the goal of targeting movie franchises for their products. This helped turn around the company’s fortunes, and today Lego is a household name all over the world.

To see the importance of confidence another way, see Figure 1.1 which displays the index of consumer sentiment, where the data are collected by surveys conducted by the University of Michigan:

Each gray bar on the diagram shows where a recession occurred. Do you see any patterns emerge? We can clearly see that each time the consumer sentiment drops for several consecutive months, there is a recession. This is not purely a coincidence! Confidence inspires people to imagine a greater future; to learn and use new technology to create a better world.

Monetary policy

The second pillar, monetary policy, is simply the process of adjusting, on an ongoing basis, the supply of money in the economy, the availability of credit, and the cost of borrowing. The implementation of monetary policy falls under the authority of the Federal Reserve Bank. The Fed monitors a myriad of economic indicators and data which decision makers use to determine the actions necessary to maintain the appropriate amount of money in the economy necessary to meet its end objectives of relatively full employment and low inflation. Working directly with the banking system, the Fed plays a key role in the way the modern monetary system operates. Depending on its goals, the Fed will implement actions which encourage expansion of credit in an attempt to stimulate economic activity or they may discourage borrowing, thereby slowing growth. Hopefully, decision makers will achieve their goals most of the time, although it can be as much art as science. Using a variety of available tools, Fed authorities constantly seek to create the perfect balance in the economy which will allow it to thrive. It is not unlike Goldilocks’ search in the classic fairy tale for the perfect porridge that is ‘not too hot, not too cold, but just right.’ And what is just right in one set of circumstances may spell disaster in another. With so many moving parts and an ever-changing fiscal environment, there is no single prescription to cure a particular ill. Monetary policy experts are constantly forecasting and attempting to make the most accurate predictions possible, as their decisions are the ones most likely to affect the economic lives of individuals. They carry a huge burden. Still, the obligation to get it right is not theirs alone, as monetary policy works alongside fiscal policy and the two must be well synchronized to create the best macroeconomic outcome.

Figure 1.1 Index of Consumer Sentiment.

Source: University of Michigan

Fiscal policy

Fiscal policy, which is the government’s use of taxation and spending, is controlled by the government. The goal of fiscal policy is to control government spending levels and set tax rates in a proper balance in order to serve the private economy. It is probably the most well-known but least understood of the three pillars. Because it is carried out by way of the body of laws established by Congress, fiscal policy is often referenced in headlines and sound bites. Taxes are of particular interest because of their direct effect on each of us. Simply stated, taxation is the government’s primary method of revenue collection. Fiscal policy seeks to balance that revenue with government spending and other regulations in a way that allows the private sector to flourish. Think of it as a tool kit. By adjusting tax revenues or budgetary spending, the government has the ability to implement changes directed at influencing and balancing aggregate demand, inflation, and gross domestic product (GDP). Historically, the portion of the private economy paid into the government through taxation was approximately 18%–20%. In more recent years, that percentage has been on a rising trajectory: the Organization for Economic Co-operation and Development (OECD) reports that the tax-to-GDP ratio was about 24% for the United States in 2018, meaning the government’s size relative to the private economy continues to expand. Many believe that amount to be excessive because the revenue being funneled into a government program takes away from stimulating the private economy. Others believe that large government programs make such a great contribution to the well-being of the citizens that, to them, paying higher taxes is a justified way to redistribute wealth. Further, government spending does pour money into the private economy when it is being used to purchase goods and services for government projects, and there are theories that support the idea that deficit spending is a worthwhile stimulus for a sluggish economy.

While there are differing economic theories and opposing viewpoints, all agree that fiscal policy does have an impact on the health of the economy and it is clear that, to maximize its effectiveness, it must be executed in concert with monetary policy. Some argue that the role of monetary policy should be secondary to that of fiscal policy while others maintain that, when it comes to government regulation, less is more. Many believe that the government should provide the regulatory framework and then step out of the way, allowing the economy to thrive without the suppression of excessive governmental bureaucracy. Regardless of political leanings, all would agree that governments are necessary to create a balanced playing field and to protect property rights.

GDP

The previous discussion referenced the term GDP. An acronym for Gross Domestic Product, it is frequently used in economic discussions, but many do not really understand what it means. Why do we monitor GDP? How is it calculated? And why is it considered one of the most important measures of the economy’s health and citizens’ standard of living?

In a nutshell, GDP is simply the market value, in U.S. dollars, of all officially recognized final goods and services produced within a country in a given time period. The word final, as used here, means that the value of a given good or service that is produced is counted at the point of completion of the good or service, and the various components and wages are already included within that final value. In other words, although a car might be comprised of metal, glass, tires, etc., the individual parts (i.e. the windshield, the tires) are only included once in GDP as part of the final production value of the car. If they were sold separately, as when you purchase a new set of tires for your car, they are counted because they are being sold for final use.

Although there are several methods for calculating GDP, each method produces approximately the same result. Understanding GDP is an important building block to understanding the macroeconomy, because it measures, in the broadest sense, the economic health of nations. Is the economy growing at a reasonable rate to provide relatively full employment for those able to work? Are we earning a gradual and continuously improving standard of living as a nation? Is the final GDP calculation for a given year the real growth of the nation, or is it being expressed in current prices at current dollar values, also referred to as nominal GDP, without an adjustment for inflation? All of these questions hinge on a basic understanding of GDP and its role in measuring the economy.

As we just stated, GDP is the market value of all officially recognized final goods and services produced within a country in a given period of time. While GDP is arguably the best measure of well-being we have in macroeconomics, it is not a perfect measure—there are several reasons why this is the case. First, only newly produced goods are counted within GDP. So, the purchase of a new car gets counted in GDP, but transactions of used cars do not. Second...