p> Borrowing from Foreign SaversThe flow of funds from other nations enables U.S. firms to finance more
investments in capital goods, but it also creates concerns. For example,
in order for foreigners to invest in U.S. savings accounts and U.S.
government or corporate bonds, they must have dollars. As they demand
dollars for these investments, the price of the dollar in terms of other
nations’ currencies rises. When the price of the dollar is rising, people
in other countries who want to buy U.S. exports will have to pay more for
them. That means they will buy fewer goods and services produced in the
United States, which will hurt U.S. export industries. This happened in
the early 1980s, when U.S. companies such as Caterpillar, which makes
large engines and industrial equipment, saw the sales of their products
to their international customers plummet. The higher value of the dollar
also makes it cheaper for U.S. citizens to import products from other
nations. Imports will rise, leading to a larger deficit (or smaller
surplus) in the U.S. balance of trade, the amount of exports compared to
imports. Foreign investment has other effects on the U.S. economy. Eventually the
money borrowed must be repaid. How those repayments will affect the U.S.
economy will depend on how the borrowed money is invested. If the money
borrowed from foreign individuals and companies is put into capital
projects that increase levels of output and income in the United States,
repayments can be made without any decrease in U.S. living standards.
Otherwise, U.S. living standards will decline as goods and services are
sent overseas to repay the loans. The concern is that instead of using
foreign funds for additional investments in capital goods, today these
funds are simply making it possible for U.S. consumers and government
agencies to spend more on consumption goods and social services, which
will not increase output and living standards. In the early history of the United States, many U.S. capital projects
were financed by people in Britain, France, and other nations that were
then the wealthiest countries in the world. These loans helped the
fledgling U.S. economy to grow and were paid off without lowering the
U.S. standard of living. It is not clear that current U.S. borrowing from
foreign nations will turn out as well and will be used to invest in
capital projects, now that the United States, with the largest and
wealthiest economy in the world, faces a low national savings rate. MONEY AND FINANCIAL MARKETS A Money and the Value of Money
Money is anything generally accepted as final payment for goods and
services. Throughout history many things have been used around the world
as money, including gold, silver, tobacco, cattle, and rare feathers or
animal skins. In the U.S. economy today, there are three basic forms of
money: currency (dollar bills), coins, and checks drawn on deposits at
banks and other financial firms that offer checking services. Most of the
time, when households, businesses, and government agencies pay their
bills they use checks, but for smaller purchases they also use currency
or coins.
People can change the type of the money they hold by withdrawing funds
from their checking account to receive currency or coins, or by
depositing currency and coins in their checking accounts. But the money
that people have in their checking accounts is really just the balance in
that account, and most of those balances are never converted to currency
or coins. Most people deposit their paychecks and then write checks to
pay most of their bills. They only convert a small part of their pay to
currency and coins. Strange as it seems, therefore, most money in the
U.S. economy is just the dollar amount written on checks or showing in
checking account balances. Sometimes, economists also count money in
savings accounts in broader measures of the U.S. money supply, because it
is easy and inexpensive to move money from savings accounts to checking
accounts. Most people are surprised to learn that when banks make loans, the loans
create new money in the economy. As we’ve seen, banks earn profits by
lending out some of the money that people have deposited. A bank can make
loans safely because on most days, the amount some customers are
depositing in the bank is about the same amount that other customers are
withdrawing. A bank with many customers holding a lot of deposits can
lend out a lot of money and earn interest on those loans. But of course
when that happens, the bank does not subtract the amount it has loaned
out from the accounts of the people who deposited funds in savings and
checking accounts. Instead, these depositors still have the money in
their accounts, but now the people and firms to whom the bank has loaned
money also have that money in their accounts to spend. That means the
total amount of money in the economy has increased. This process is
called fractional reserve banking, because after making loans the bank
retains only a fraction of its deposits as reserves. The bank really
could not pay all of its depositors without calling in the loans it has
made. It also means that money is created when banks make loans but
destroyed when loans are paid off. At one time the dollar, like most other national currencies, was backed
by a specified quantity of gold or silver held by the federal government.
At that time, people could redeem their dollars for gold or silver. But
in practice paper currency is much easier to carry around than large
amounts of gold or silver. Therefore, most people have preferred to hold
paper money or checking balances, as long as paper currency and checks
are accepted as payment for goods and services and maintain their value
in terms of the amount of goods and services they can buy. Eventually governments around the world also found it expensive to hold
and guard large quantities of gold or silver. As foreign trade grew,
governments found it especially difficult to transfer gold and silver to
other countries that decided to redeem paper money acquired through
international trade. They, too, changed to using paper currencies and
writing checks against deposits in accounts. In 1971 the United States
suspended the international payment of gold for U.S. currency. This
action effectively ended the gold standard, the name for this official
link between the dollar and the price of gold. Since then, there has been
no official link between the dollar and a set price for gold, or to the
amount of gold or other precious metals held by the U.S. government. The real value of the dollar today depends only on the amount of goods
and services a dollar can purchase. That purchasing power depends
primarily on the relationship between the number of dollars people are
holding as currency and in their checking and savings accounts, and the
quantity of goods and services that are produced in the economy each
year. If the number of dollars increases much more rapidly than the
quantity of goods and services produced each year, or if people start
spending the dollars they hold more rapidly, the result is likely to be
inflation. Inflation is an increase in the average price of all goods and
services. In other words, it is a decrease in the value of what each
dollar can buy. The Federal Reserve System and Monetary Policy Governments often attempt to reduce inflation by controlling the supply
of money. Consequently, organizations that control how much money is
issued in an economy play a major role in how the economy performs, in
terms of prices, output and employment levels, and economic growth. In
the United States, that organization is the nation’s central bank, the
Federal Reserve System. The system’s name comes from the fact that the
Federal Reserve has the legal authority to make banks hold some of their
deposits as reserves, which means the banks cannot lend out those
deposits. These reserve funds are held in the Federal Reserve Bank. The
Federal Reserve also acts as the banker for the federal government, but
the government does not own the Federal Reserve. It is actually owned by
the nation’s banks, which by law must join the Federal Reserve System and
observe its regulations. There are 12 regional Federal Reserve banks. These banks are not
commercial banks. They do not accept savings deposits from or provide
loans to individuals or businesses. Instead, the Federal Reserve
functions as a central bank for other banks and for the federal
government. In that role the Federal Reserve System performs several
important functions in the national economy. First, the branches of the
Federal Reserve distribute paper currency in their regions. Dollar bills
are actually Federal Reserve notes. You can look at a dollar bill of any
denomination and see the number for the regional Federal Reserve Bank
where the bill was originally issued. But of course the dollar is a
national currency, so a bill issued by any regional Federal Reserve Bank
is good anyplace in the country. The distribution of currency occurs as
commercial banks convert some of their reserve balances at the Federal
Reserve System into currency, and then provide that currency to bank
depositors who decide to hold some of their money balances as currency
rather than deposits in checking accounts. The U.S. Treasury prints new
currency for the Federal Reserve System. The bills are introduced into
circulation when commercial banks use their reserves to buy currency from
the Federal Reserve Bank. Second, the regional Federal Reserve banks transfer funds for checks that
are deposited by a bank in one part of the country, but were written by
someone who has a checking account with a bank in another part of the
country. Millions of checks are processed this way every business day.
Third, the regional Federal Reserve Banks collect and analyze data on the
economic performance of their regions, and provide that information and
their analysis of it to the national Federal Reserve System. Each of the
12 regions served by the Federal Reserve banks has its own economic
characteristics. Some of these regional economies are concerned more with
agricultural issues than others; some with different types of
manufacturing and industries; some with international trade; and some
with financial markets and firms. After reviewing the reports from all
different parts of the country, the national Federal Reserve System then
adopts policies that have major effects on the entire U.S. economy. By far the most important function of the Federal Reserve System is
controlling the nation’s money supply and the overall availability of
credit in the economy. If the Federal Reserve System wants to put more
money in the economy, it does not ask the Treasury to print more dollar
bills. Remember, much more money is held in checking and savings accounts
than as currency, and it is through those deposit accounts that the
Federal Reserve System most directly controls the money supply. The
Federal Reserve affects deposit accounts in one of three ways. First, it can allow banks to hold a smaller percentage of their deposits
as reserves at the Federal Reserve System. A lower reserve requirement
allows banks to make more loans and earn more money from the interest
paid on those loans. Banks making more loans increase the money supply.
Conversely, a higher reserve requirement reduces the amount of loans
banks can make, which reduces or tightens the money supply. The second way the Federal Reserve System can put more money into the
economy is by lowering the rate it charges banks when they borrow money
from the Federal Reserve System. This particular interest rate is known
as the discount rate. When the discount rate goes down, it is more likely
that banks will borrow money from the Federal Reserve System, to cover
their reserve requirements and support more loans to borrowers. Once
again, those loans will increase the nation’s money supply. Therefore, a
decrease in the discount rate can increase the money supply, while an
increase in the discount rate can decrease the money supply. In practice, however, banks rarely borrow money from the Federal Reserve,
so changes in the discount rate are more important as a signal of whether
the Federal Reserve wants to increase or decrease the money supply. For
example, raising the discount rate may alert banks that the Federal
Reserve might take other actions, such as increasing the reserve
requirement. That signal can lead banks to reduce the amount of loans
they are making. The third way the Federal Reserve System can adjust the supply of money
and the availability of credit in the economy is through its open market
operations—the buying or selling of government bonds. Open market
operations are actually the tool that the Federal Reserve uses most often
to change the money supply. These open-market operations take place in
the market for government securities. The U.S. government borrows money
by issuing bonds that are regularly auctioned on the bond market in New
York. The Federal Reserve System is one of the largest purchasers of
those bonds, and the bank changes the amount of money in the economy when
it buys or sells bonds. Government bonds are not money, because they are not generally accepted
as final payment for goods and services. (Just try paying for a hamburger
with a government savings bond.) But when the Federal Reserve System pays
for a federal government bond with a check, that check is new
money—specifically, it represents a loan to the government. This loan
creates a higher balance in the government’s own checking account after
the funds have been transferred from the privately owned Federal Reserve
Bank to the government. That new money is put into the economy as soon as
the government spends the funds. On the other hand, if the Federal
Reserve sells government bonds, it collects money that is taken out of
circulation, since the bonds that the Federal Reserve sells to banks,
firms, or households cannot be used as money until they are redeemed at a
later date. The Wall Street Journal and other financial media regularly report on
purchases of bonds made by the Federal Reserve and other buyers at
auctions of U.S. government bonds. The Federal Reserve System itself also
publishes a record of its buying and selling in the bond market. In
practice, since the U.S. economy is growing and the money supply must
grow with it to keep prices stable, the Federal Reserve is almost always
buying bonds, not selling them. What changes over time is how fast the
Federal Reserve wants the money supply to grow, and how many dollars
worth of bonds it purchases from month to month. To summarize the Federal Reserve System’s tools of monetary policy: It
can increase the supply of money and the availability of credit by
lowering the percentage of deposits that banks must hold as reserves at
the Federal Reserve System, by lowering the discount rate, or by
purchasing government bonds through open market operations. The Federal
Reserve System can decrease the supply of money and the availability of
credit by raising reserve ratios, raising the discount rate, or by
selling government bonds. The Federal Reserve System increases the money supply when it wants to
encourage more spending in the economy, and especially when it is
concerned about high levels of unemployment. Increasing the money supply
usually decreases interest rates—which are the price of money paid by
those who borrow funds to those who save and lend them. Lower interest
rates encourage more investment spending by businesses, and more spending
by households for houses, automobiles, and other “big ticket” items that
are often financed by borrowing money. That additional spending increases
national levels of production, employment, and income. However, the
Federal Reserve Bank must be very careful when increasing the money
supply. If it does so when the economy is already operating close to full
employment, the additional spending will increase only prices, not output
and employment. Effect of Monetary Policies on the U.S. Economy The monetary policies adopted by the Federal Reserve System can have
dramatic effects on the national economy and, in particular, on financial
markets. Most directly, of course, when the Federal Reserve System
increases the money supply and expands the availability of credit, then
the interest rate, which determines the amount of money that borrowers
pay for loans, is likely to decrease. Lower interest rates, in turn, will
encourage businesses to borrow more money to invest in capital goods, and
will stimulate households to borrow more money to purchase housing,
automobiles, and other goods.
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