Eco 360 Week Three Chapter Summary

Chapter 27

Chapter 27 contained information on money, banking, and the financial sector. The financial sector is the market where financial assets are created and exchanged (Colander, 2006). It channels flow out of circular flow and back into the circular flow (Colander, 2006). Interest rates, inflation, employment, and oil prices affect the financial sector. First are the interest rates. There are several theories on interest rates. The most popular is the expectations theory defined as the yield or interest rate is derived from expectations. Ultimately people have expectations that the interest rate will prevail. If the rate will prevail then the demand will keep the interest rates up. There is also the force of the Federal system. This usually occurs when a bad economic situation occurs; the Fed will pump money into the economy to stimulate the economy. A perfect example is what is happening now. Many people are receiving tax rebate checks. The government wants to stimulate the economy by giving people money to in turn, spend it. When the Federal Reserve expands the number of dollars, certain sectors get the new Fed money first. Those sectors are (1) the government, and those who do the most business with the government and (2) the banking system, and those who do the most business with banks. This means that people would expect to first see the impact of an expanded money supply in the Big Business and Big Banking sectors. Eventually the new Fed money has to work its way through the entire economy, raising prices on everything people buy. When the FED drops the rate, the US the dollar drops in value. This lowers the interest rate on investment returns; CD's long and short term bonds etc. The market responds to this by buying higher priced oversea stock and bonds which have a higher return. This has the effect of lowering the US dollar even more and then the foreign money markets sell there holdings in US dollars which further lowers the value. This particular rate drop was intended to reduce the impact of mortgage defaults. People walking away from mortgages and losing his or her homes has enormous downstream effects on the economy beyond the capital markets. Additionally lower rates cause the dollar to devalue against foreign currency, making imports more expensive and similarly, makes our exports more competitive. The impact of a devalued dollar and increased leveraged consumer spending tends to trigger inflation, forcing rates to go back up.

Chapter 28

Chapter 28 explained the monetary policy and the debate about macro policy. The monetary policy is the policy of influencing the economy through changes in the banking system’s reserves that affect the money supply (Colander, 2006). In the U.S. the central bank (the Fed) does not print money; the U.S. Treasury Department does that. The Fed directly sets the discount rate which is the rate of interest that it charges banks to borrow reserves from the Fed. The Fed also sets a target rate for the federal funds rate which is the rate of interest that banks charge for borrowing reserves from one another. The Fed then uses open market operations, buying and selling treasury securities, in order to influence the federal funds rate. Because monetary policy can affect inflation expectations as well as nominal interest rates, the effect of monetary policy on interest rates can be uncertain (Colander, 2006). Problems of monetary policy include knowing what policy to use, knowing what policy people are using, lags, liquidity traps, political pressure, and conflicting international goals (Colander, 2006). Monetary policy has a couple of issues. Other than previously mentioned the biggest impact is that it tends to emphasize the boom bust cycle. As an economy recesses, interest rates are lowered, and investment and non-investment borrowing increases. This strengthens the economy but is very hard to balance and suddenly people find the economy overheated. So interest rates are increased. This causes hardship on those with debt and can often hit the poorest the hardest.

As the economy becomes more complex, more and more investment

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