where DI is disposable income, and because dispos-

able income and GDP are related by the accounting Thus, the multiplier is 6,002.5 2 6,000 5 2.5, as stated

identity in the text.

To find the multiplier for an increase in fixed taxes,

DI 5 Y 2 T

change the tax schedule as follows:

it follows that the C schedule used in the 45° line dia-

T 5 0.20Y 1 1

gram is described by the following algebraic equation:

Disposable income is then

C 5 300 1 0.75(Y 2 T)

DI 5 Y 2 T 5 Y 2 (0.20Y 1 1) 5 0.80Y 2 1

5 300 1 0.75(Y 2 0.20Y)

5 300 1 0.75(0.80Y)

5 300 1 0.60Y

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Chapter 11 239

Managing Aggregate Demand: Fiscal Policy

so the consumption function is or

C 5 300 1 0.75DI a 2 bT0 1 I 1 G 1 (X 2 IM)

(6)

Y5

5 300 1 0.75(0.80Y 2 1) 1 2 b(1 2 t)

5 299.25 1 0.60Y Equation (6) shows us that the multiplier for G, I, a, or

(X 2 IM) is

Solving for equilibrium GDP as usual gives:

1

Y 5 C 1 I 1 G 1 (X 2 IM) Multiplier 5 .

1 2 b(1 2 t)

Y 5 299.25 1 0.60Y 1 900 1 1,300 2 100

To see that this is in fact the multiplier, raise any of G,

0.40Y 5 2,399.25

I, a, or (X 2 IM) by one unit. In each case, Equation (6)

Y 5 5,998.125

would be changed to read:

So a $1 increase in fixed taxes lowers Y by $1.875. The

a 2 bT0 1 I 1 G 1 1 X 2 IM 2 1 1

tax multiplier is 21.875, which is 75 percent of 22.5.

Y5

1 2 b 11 2 t2

Now let us proceed to a more general solution, using

symbols rather than specific numbers. The equations of

Subtracting Equation (6) from this expression gives

the model are as follows:

the change in Y stemming from a one-unit change in

Y 5 C 1 I 1 G 1 (X 2 IM) (1) G, I, or a:

is the usual equilibrium condition. 1

Change in Y 5

1 2 b 11 2 t2

(2)

C 5 a 1 bDI

is the same consumption function we used in Appen- In Chapter 9 (page 188, we noted that if there were no

dix A of Chapter 9. income tax (t 5 0), a realistic value for b (the marginal

propensity to consume) would yield a multiplier of 20,

(3)

DI 5 Y 2 T

which is much bigger than the true multiplier. Now

is the accounting identity relating disposable income that we have added taxes to the model, our multiplier

to GDP. formula produces much more realistic numbers.

Approximate values for these parameters for the U.S.

(4)

T 5 T0 1 tY

economy are b 5 0.95 and t 5 1„3. The multiplier for-

is the tax function, where T0 represents fixed taxes mula then gives

(which are zero in our numerical example) and t rep-

1

resents the tax rate (which is 0.20 in the example). Fi- Multiplier 5

1 2 0.95 ( 1 2 1 )

nally, I, G, and (X 2 IM) are just fixed numbers. 3

We begin the solution by substituting Equations (3) 1 1

5 2.72

and (4) into Equation (2) to derive the consumption 5 5

1 2 0.633 0.367

schedule relating C to Y:

which is much closer to its actual estimated value”

C 5 a 1 bDI

between 1.5 and 2.

C 5 a 1 b(Y 2 T)

Finally, we can see from Equation (6) that the multi-

C 5 a 1 b(Y 2 T0 2 tY) plier for a change in fixed taxes (T0) is

(5)

C 5 a 2 bT0 1 b(1 2 t)Y

2b

Tax Multiplier 5

Notice that a change in fixed taxes (T0) shifts the inter- 1 2 b(1 2 t)

cept of the C schedule, whereas a change in the tax rate

For the example considered in the text and earlier in

(t) changes its slope, as explained in Appendix A

this appendix, b 5 0.75 and t 5 0.20, so the formula

(pages 235“237).

gives

Next, substitute Equation (5) into Equation (1) to

find equilibrium GDP: 2 0.75 2 0.75

5

1 2 0.75 1 1 2 0.20 2 1 2 0.75 1 0.80 2

Y 5 C 1 I 1 G 1 (X 2 IM)

Y 5 a 2 bT0 1 b(1 2 t)Y 2 0.75 2 0.75

5 2 1.875

5 5

1 I 1 G 1 (X 2 IM) 1 2 0.60 0.40

[1 2 b(1 2 t)] Y 5 a 2 bT0 1 I 1 G 1 (X 2 IM) According to these figures, each $1 increase in T0

reduces Y by $1.875.

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Part 3

240 Fiscal and Monetary Policy

| TEST YOURSELF |

1. Consider an economy described by the following set of 3. You are given the following information about an

equations: economy:

C 5 120 1 0.80DI C 5 0.90DI

I 5 320 I 5 100

G 5 480 G 5 540

(X 2 IM) 5 280 (X 2 IM) 5 240

T 5 200 1 0.25Y T 5 2 1„3 Y

Find the equilibrium level of GDP. Next, find the multi- a. Find equilibrium GDP and the budget deficit.

pliers for government purchases and for fixed taxes. If b. Suppose the government, unhappy with the budget

full employment comes at Y 5 1,800, what are some deficit, decides to cut government spending by pre-

policies that would move GDP to that level? cisely the amount of the deficit you just found. What

2. This question is a variant of the previous problem that actually happens to GDP and the budget deficit, and

approaches things in the way that a fiscal policy plan- why?

ner might. In an economy whose consumption function 4. (More difficult) In the economy considered in Test

and tax function are as given in Test Yourself Ques- Yourself Question 3, suppose the government, seeing

tion 1, with investment fixed at 320 and net exports that it has not wiped out the deficit, keeps cutting G

fixed at 280, find the value of G that would make GDP until it succeeds in balancing the budget. What level of

equal to 1,800. GDP will then prevail?

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Money and the Banking System

[Money] is a machine for doing quickly and commodiously what would

be done, though less quickly and commodiously, without it.

J O H N S TUA RT M IL L

T he circular flow diagrams of earlier chapters showed a “financial system” in the

upper-left corner. (Look back, for example, at Figure 1 of Chapter 9 on page 177.)

Saving flowed into this system and investment flowed out. Something obviously

goes on inside the financial system to channel the saving back into investment, and it is

time we learned just what this something is.

There is another, equally important, reason for studying the financial system. The

government exercises significant control over aggregate demand by manipulating

monetary policy as well as fiscal policy. Indeed, most observers nowadays see mone-

tary policy as the more important stabilization tool. To understand how monetary

policy works (the subject of Chapters 13 and 14), we must first acquire some under-

standing of the banking and financial system. By the end of this chapter, you will have

that understanding.

CONTENTS

Other Definitions of the Money Supply BANKS AND MONEY CREATION

ISSUE: WHY ARE BANKS SO HEAVILY REGULATED?

The Limits to Money Creation by a Single Bank

THE BANKING SYSTEM

THE NATURE OF MONEY

Multiple Money Creation by a Series of Banks

How Banking Began

Barter versus Monetary Exchange

The Process in Reverse: Multiple Contractions of the

Principles of Bank Management: Profits

The Conceptual Definition of Money

Money Supply

versus Safety

What Serves as Money?

Bank Regulation WHY THE MONEY-CREATION FORMULA

HOW THE QUANTITY OF MONEY IS OVERSIMPLIFIED

THE ORIGINS OF THE MONEY SUPPLY

IS MEASURED

THE NEED FOR MONETARY POLICY

How Bankers Keep Books

M1

M2

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Licensed to:

Part 3

242 Fiscal and Monetary Policy

ISSUE: WHY ARE BANKS SO HEAVILY REGULATED?

Banking has long been one of the most heavily regulated industries in

America. But the pendulum of bank regulation has swung back and forth.

In the late 1970s and early 1980s, the United States eased several restrictions

on interest rates and permissible bank activities. Then, after a number of banks

and savings institutions went bankrupt in the 1980s, Congress and the bank reg-

ulatory agencies cracked down with stiffer regulation and much closer scrutiny.

Later, the pendulum swung back in the deregulatory direction, with two landmark bank-

ing laws passed in the 1990s. Most restrictions on banking across state lines were lifted in

1994, and the once-strict separation of banking from insurance and investment banking

was more or less ended in 1999. More recently, the mortgage meltdown that began in 2007

has raised new questions about what further regulations might be needed.

In brief, we have spent decades wrestling with the question: How much bank regu-

lation is enough”or too much? But to answer this question intelligently, we must first

address a more basic one: Why are banks so heavily regulated in the first place?

A first reason is something we will learn in the next chapter: that the major “output”

of the banking industry”the nation™s money supply”is an important determinant of aggre-

gate demand. Bank managers are paid to do what is best for their stockholders. But as we

will see, what is best for bank stockholders may not always be best for the economy as

a whole. Consequently, the government does not allow bankers to determine the money

supply and interest rates strictly on profit considerations.

A second reason for the extensive web of bank regulation is concern for the safety of

depositors. In a free-enterprise system, new businesses are born and die every day; and

no one other than the people immediately involved takes much notice. When a firm

goes bankrupt, stockholders lose money and employees may lose their jobs. But, except

for the case of very large firms, that is about all that happens.

But banking is different. If banks were treated like other firms, depositors would lose

money whenever one went bankrupt. That outcome is bad enough by itself, but the real

danger emerges in the case of a run on a bank. When depositors get nervous about the

A run on a bank occurs

when many depositors security of their money, they may all rush to cash in their accounts. For reasons we will

withdraw cash from their learn in this chapter, most banks could not survive such a “run” and would be forced

accounts all at once.

to shut their doors.

Worse yet, this disease is highly contagious. If one family hears that their neighbors

just lost their life savings because their bank went broke, they are likely to rush to their

own bank to withdraw their funds. In fact, fear of contagion is precisely what prompted

British bank regulators to act in September 2007 when Northern Rock, a bank special-

izing in home mortgages, experienced a highly publicized run. (See the box “It™s Not

Such a Wonderful Life” on page 249.) They first guaranteed all deposits in Northern

Rock and later extended the guarantee to all British banks.1

Without modern forms of bank regulation, therefore, one bank failure might lead to

another. Indeed, bank failures were common throughout most of U.S. history. (See

Figure 1(a).) But since the 1930s, bank failures have been less common. (See Figure 1(b),

and notice the sharply different scale.) And they have rarely been precipitated by runs

because the government has taken steps to ensure that such an infectious disease will

not spread. It has done so in several ways that we will mention in this chapter.

THE NATURE OF MONEY

Money is so much a part of our daily existence that we take it for granted and fail to appre-

ciate all that it accomplishes. But money is in no sense “natural.” Like the wheel, it had to

be invented.

The United Kingdom did not have a deposit insurance system comparable to the Federal Deposit Insurance

1

Corporation (FDIC) in the United States.