how the government influences the economy

Interest Rates

Government can make the economy better or worse by two primary ways:
1.               Fluctuating interest rates

2.               Increasing or decreasing the money supply.

Interest Rates

The government can change the interest rate that applies to banks when they borrow money from the government.  Banks borrow money from the government to make loans to people and businesses.  Banks charge people more money than businesses, and pocket the difference.  [credit card example].

Gvmt increases interest rates to slow the economy.  Interest rates go up, banks charge customers more interest on credit cards, car loans and home loans, and consumers spend less, slowing the economy.
Gvmt lowers interest rates to stimulate economy.  Interest rates go down, banks charge customers less to borrow money, and consumers spend more, stimulating the economy.
Government has been lowering interest rates for the past year to encourage people to spend their money and not save it, therefore stimulating the economy. Lately, many credit card interest rates have dropped from 19% to 16%, and from 9% to 6%.

Money Supply

Total amount of money in circulation is almost 6 trillion dollars.  Originally, the money in America was backed by gold – a dollar bill was a receipt for one dollar worth of gold in Fort Knox.  But we needed more cash than there was gold, so we no longer have a currency backed by gold.  What is currency backed by?  Faith in the government.  OK in US, but in some countries faith isn’t enough, and the economy and currency can collapse.
A lot of that money is kept in banks, which is insured by the government up to $100k per account.  Banks have three main purposes:  Hold deposits, make loans, and transfer money.
Banks keep a portion of their deposits in reserve, say 15%.  Some of that gets sent to the Federal Reserve Banks for safekeeping.  The rest of the money gets loaned.
$100 – deposit
(15) – reserve
(85) – loan
85 loan for a car, car dealer deposits in bank.
(13) reserve
(72) – loan
Initial $100 has turned into $157 addition to money supply in just two simple transactions.
Eventually, a calculation tells us the $100 would generate $666 in new money.
When the loans are repayed, the money supply is reduced.  Money supply always expanding and contracting.  In general, money supply expands when economy is good because lots of loans for expansion, contracts when economy is bad, because people aren’t making/taking loans.
15% reserve goes into Federal Reserve System – government bank that banks put their money in.  They print money, processes the checks people write, regulate money supply, and set interest rates.


Right now we are starting to experience inflation:  Cost of electricity and natural gas going up, cost of car fuel going up ($3/gal?).  Workers will start asking for more money from their employers to pay for increased costs, and employers will pass those costs on to customers in the form of higher prices … the cycle continues, and that is inflation.  Typically 2-3% per year.  Bad if it gets to 5% or higher.  Who suffers the most?  People who don’t have the ability to demand higher wages – hourly workers.  Some countries have experienced hyperinflation – 100% - 500%, i.e. Mexico, where pesos became worthless.

Economic Indicators

Alan Greenspan cut interest rates again yesterday – 5th time in a year, to 4%.  He’s now cut it a total of 2.5%.
Importance:  Indicates where economy is headed.  Government uses these indicators to affect interest rates and money supply to influence the economy.  Why is this important for you to know?  If you listen to the news and pay attention to these indicators, you will know when to buy and sell stock.  When the indicators are turning bad, sell.  When they’re bad, buy.  Turning good – hold.  Good – sell.  It’s a cycle.

1.      Money Supply: Book (and last week I) says Dec 1998 M3 at 5.983 trillion; now at 7.315 trillion. Increased 10% in the last year.  Now increasing at about 3%.  Fed increases money supply by printing new money and lending to banks to lend to consumers.  Increases spending, makes economy grow faster.  Reducing money supply slows the economy.
2.      Inflation:  Measures the increase in costs.  Near 3% now.  Usually around 2-2.5%.  Example:  Let’s say that in 1983, when some of you were born, your parents went to the grocery store and bought two weeks worth of groceries.  They spent $100.  How much would those exact same groceries cost today?  $173.  Not really a problem if everyone’s wages keep up … but often they don’t, especially menial jobs.  1983 minimum wage $3.35.  Today’s dollars: $5.76.  What is minimum wage today in CA?  $6.75?

Negative inflation?  Sure – things getting cheaper to buy – example- price of gas going down!

Russia has 88% inflation.  Things today cost 88% more than they cost a year ago.  Wages can’t keep up with that.  Developed countries usually have 1-3%.
3.      Unemployment:  Percentage of able bodied people unemployed.  Nationally at 4.5%, up slightly from earlier in the year – 4.2%.  Fluctuates widely between 4% and 8%.  In 1992, it was at 7.5%.  In 1983, it was at nearly 10% - 50 year high.  Santa Clara County lower.
4.      Gross Domestic Product (GDP):  Total value of all goods and services produced in the country.  Includes all the products and services we buy, products businesses buy (machinery), government spending, and net exports (-300B - a negative number because we import more than we export).  Generally increases steadily.

Measured total (Gross Domestic Product) in trillions of dollars – $2.5 in 1975; 8.2 in 1998.  $10T currently.  Japan $3T.  China 5T.  Worldwide GDP is $41T

Measured per capita (per person): $7,500 in 1975; 31,000 in 1998.  33,900 now. about $7k per person worldwide.

Measured in terms of % increase (most important indicator):  3-8% increase per year.  Late 1999 went up 8%; 2000 at .25%, now at 2%.  Indicates our economy has slowed way down.
5.      Consumer confidence / retail sales:  April it was at 92, verus 88 earlier in the year – rising.
What do they do with this info?  Adjust money supply, adjust interest rates.  Effect is increasing spending, which increases GDP, lowers unemployment, increases consumer confidence, but also increases inflation.

Popular posts from this blog

power elite vs pluralist explanation models

big 4 vs. law firm comparison from an industry perspective

california bar exam primer