REVIEW: MULTIPLIER ANALYSISZ = C+I+GZ=Y in equilibriumC = c + c (Y-T)Result: 45-degree diagramIMPLICATIONS:1. Spending good, saving bad2. Fiscal policy (G or T) can be used to stimulate economyBut is this right?1. Economy is limited by capacity – the supply sidematters. More on this later in the course.2. Spending depends on more than income. Financialmarkets play a crucial role, too.3. There is another lever of policy: Monetary policyFINANCIAL ASSETS: A PARTIAL LIST1. Stocks: ownership claims on companies, entitling ownerto a share of profits2. Bonds: entitles owner to a steady flow of interestpayments3. MoneyIndividuals hold a portfolio of different assets; reallocatetheir wealth among assets based on market returns,expectations, etc.Monetary policy involves changing the quantity of money.Monetary, not fiscal policy is actually the main tool used tofight recessions and rein in booms.To understand the role of money and monetary policy, weignore stocks and imagine an economy in which bonds andmoney are the only two assets.BONDS: Think of one-period bond. You buy it for $1, get$(1+i) one year laterActual bonds are often multi-period. E.g., you buy for $1,receive $i each year for next 10 years, then get your $1back. Typical maturities range from 1 day (Fed funds rate),to 90 days (Treasury bills), to 30 years (Long term gov’tbonds)What happens if there is news after a bond is issued,changing peoples’ demands? The price of a bond rises orfalls, in order to make the effective yield match the market.Bond price up = interest rate downBond price down = interest rate upTHE ROLES OF MONEY1. Money is a medium of exchange: sell goods for money,use money to buy goods; barter (direct swapping ofgoods is rare)2. Money is a unit of account: prices are quoted in moneyterms3. Money is a store of value: it is one way to carry overwealth from present to futureSo what is money? Money and wealth are not the samethings. (You can’t give the clerk at 7-11 a share in Yahoo!)Conventional definition is wealth that can serve as mediumof exchange. This definitely includes:1. Currency (green stuff)2. Checkable depositsIt could include other things – e.g. deposits with limitedchecking, money-market funds, even credit-card limits.Usually in practice we use M1 – currency + checkabledeposits – or M2, which is a broader “monetary aggregate”THE DEMAND FOR AND SUPPLY OF MONEYWhy hold money? Convenience, a.k.a. liquidityWhy not hold money? It pays little or no interestThis tradeoff determines the demand for money.What determines the supply of money? Alan Greenspan!THE FEDERAL RESERVE AND THE MONEY SUPPLYThe Federal Reserve is America’s central bank. It has theunique right to create U.S. dollars. Counterparts abroad: theBank of Japan, the Bundesbank, the Bank of England, etc..Jan. 1 the Bundesbank, Banque de France, Banca d’Italiawill cede their roles to the new European Central Bank.A central bank’s balance sheet (simplified):Assets LiabilitiesGovernment bonds MoneyIn an open-market operation the CB prints money to buymore bonds, putting more money into circulation – or sellsbonds to withdraw money from circulation. This affects theinterest rate – and because the interest rate affects spending,it affects the economy as a
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