Syllabus for Fall 2008

[Syllabus in pdf format]

Course: Economics 470/570 Monetary Theory and Policy
Professor: Mark Thoma
Office/Hours:
PLC 471 on T/Th 2:00-3:00 p.m.
Phone/Email:
(541) 346-4673, mthoma@uoregon.edu
Web Page:
http://darkwing.uoregon.edu/~mthoma/

Text: Frederic S. Mishkin, The Economics of Money, Banking, and Financial Markets, 8th edition (Addison Wesley: New York).

Prerequisites: Economics 313 or the equivalent.

GTF/Office/Hours: Isaac Swenson: Isaac@uoregon.edu, PLC 507, M/W: 3:30-4:30. 

Tests: There will be two midterms and a final. The midterms will be given on Tuesday, October 21st and Tuesday, November 18th. The final will be given on Monday, December 8th from 8:00 a.m. – 10:00 a.m. 

Homework: Problem sets will be assigned periodically. These are graded, and exam questions will be based, in part, upon the problem sets.

Grading: Each midterm is worth 25%, the homework counts as 15%, and the final is worth 35%.  Grades will be assigned according to your relative standing in the class.

Course Outline:

Introduction Mishkin Text
Introduction Ch. 1, 2
The Role of Money in the Macroeconomy Ch. 3, Ch. 4 pgs. 87-90
Central Banking and the Conduct of Monetary Policy
Structure of Central Banks and the Federal Reserve System Ch. 12
Bank Reserves and the Money Supply Ch. 13
Determinants of the Money Supply Ch. 14
Tools of Monetary Policy Ch. 15
Monetary Theory
The Demand for Money Ch. 19
The Keynesian Framework Ch. 20
Monetary and Fiscal Policy Ch. 21
The AS-AD Model Ch. 22
Money and Inflation Ch. 24
Rational Expectations: Theory and Policy Implications Ch. 25

December 14, 2008

YouTube Class Video Playlist

December 04, 2008

Class Materials for Lecture 17

Brief Outline of Topics Covered in Lecture 17

Chapter 25 Rational Expectations and Implications for Policy

  • New Classical Macroeconomics Model
    • Effects of unanticipated and anticipated policy
    • Can an expansionary policy lead to a decline in aggregate output?
    • Policy ineffectiveness and implications for policymakers
  • New Keynesian Model 
    • Effects of unanticipated and anticipated policy
    • Implications for policymakers
  • Comparisons of New Classical, New Keynesian, and Traditional Keynesian Models 
    • Short-Run Output and Price Responses

Video:

Materials from class:

Lecture16fig1

Lecture16fig2

Lecture16fig3

Lecture16fig4

Lecture16fig5

Lecture16fig6

Additional Reading:

Application:

Tim Duy:

Potentially Very Bad Policy, by Tim Duy: Incoming data confirms that the economy slid into the heart of the recession in the fourth quarter. The ISM nonmanufacturing report posted a stunning decline in service sector activity. Like its manufacturing cousin, the underlying details were simply depressing, with the drop in the employment component setting the stage for a particularly week labor report later this week. ADP reported a sharp drop in private employment in November; this report has been underestimating declines in recent months, suggesting the possibility of a blowout number. Auto sales fell off a cliff in November, and I doubt December is looking much better. TheBeige Book provided grim anecdotal evidence consistent with the data.

Unfortunately, we will have more months of such data. With the economy already a year into recession, with the worst still ahead, not behind, policymakers will become increasingly desperate to do “something.” And that is exactly when some of the worst policy will evolve.

In the heat of the moment, we love crisis managers. But actions taken by crisis managers, who would argue that something just needs to be done, can yield very bad outcomes over the longer run. As much as I respect incoming administration members Timothy Geithner and Larry Summers, their efforts at crisis management during the Asian Financial Crisis left long lasting effects on the global financial system. During the Asian Financial Crisis, US Treasury officials thought it best to use the IMF as a club to beat struggling economies into submission. As a result, foreign policymakers around the world thought it best to accumulate massive reserves that fundamentally altered the path of capital formation in order to make the IMF irrelevant. Quietly watching while the US current account deficit expanded validated the global perception of the US as consumer of last resort and further aggravated global imbalances. And if you don’t believe those imbalances are at or near the heart of the current crisis, I urge you to read Brad Setser. Separately, the Federal Reserve in 1998 took on the job of financial market guardian with the LTCM unwind, thereby setting an expectation that the Fed would always prevent anything very bad from happening. But after taking on the responsibility, the Fed never followed through on oversight. Shouldn’t Citi’s off-balance sheet entities have raised more questions?

Continue reading "Class Materials for Lecture 17" »

December 02, 2008

Class Materials for Lecture 16

Brief Outline of Topics Covered in Lecture 13

Chapter 24 Money and Inflation

  • Inflation
    • Monetarist view
    • Keynesian view
    • Supply shocks
    • Always a monetary phenomena?
  • How does inflationary policy arise?
    • Cost push - demand for higher wages
    • Demand pull - shooting at the wrong target
  • Budget deficits and inflation
  • Debt monetization

Materials from class:

Lecture14fig1

Lecture14fig2

Lecture14fig3_1

Video:

Additional Reading:

Application:

Federal Reserve Policies in the Financial Crisis, by Ben Bernanke, Federal Reserve: ...[O]ur nation ... is being tested by economic and financial challenges. Those challenges and the Federal Reserve's policy responses are the topic of my remarks today.

Federal Reserve Policies during the Crisis
As you know, this extraordinary period of financial turbulence is now well into its second year. ...

The Federal Reserve's strategy for dealing with the financial crisis and its economic consequences has had three components.

Continue reading "Class Materials for Lecture 16" »

November 30, 2008

Review Questions - Material after Midterm 2

Review for first midterm is here.
Review for second midterm is here.

Review questions for material since the second midterm:

Definitions

Potential or natural rate of output
Short-run aggregate supply
Long-run aggregate supply
Debt monetization
Inflation
Cost push inflation
Demand pull inflation
Activist/non-activist
Data lag
Recognition lag
Legislative lag
Implementation lag
Effectiveness lag
Policy ineffectiveness proposition
Rational expectations
Price rigidity

Essay

1. Show that the Fed cannot continuously hit both a money supply target and an interest rate target, i.e. that it must choose one or the other.

2. Explain Poole's rules.

3. Do changes in the money supply and government spending affect output in the long-run? Explain using the IS-LM model.

4. Derive the aggregate demand curve from the IS-LM model and explain intuitively why it slopes downward. What factors cause the AD curve to shift? In what direction do they shift the AD curve?

5. Why does the short-run aggregate supply curve slope upward? What factors cause the aggregate supply curve to shift?

6. Is the economy self-correcting? What problems are encountered in the pursuit of activist policies?

7. What causes the LRAS curve to shift, i.e. what factors affect the natural rate of output? Explain.

8. (a) Do Monetarists agree with Friedman's contention that inflation is always and everywhere a monetary phenomenon? Explain using the AD-AS model. (b) Do Keynesians agree with Friedman's contention that inflation is always and everywhere a monetary phenomenon? Explain using the AD-AS model.

9. Explain how the pursuit of a high employment target by policymakers can lead to inflation.

10. Can budget deficits lead to inflation? Explain.

11. Why might governments choose to monetize the debt?

12. Compare and contrast the effects of an unexpected increase or decrease in the money supply on prices and output in the traditional Keynesian, New Classical, and New Keynesian models.

13. Compare and contrast the effects of an expected increase or decrease in the money supply on prices and output in the traditional Keynesian, New Classical, and New Keynesian models.

14. Suppose the monetary authority wants to stop inflation rate. Compare the costs (in terms of output) of reducing inflation in the traditional Keynesian, New Classical, and New Keynesian models. Be sure to cover both an expected and an unexpected change in policy. Why is the credibility of policymakers important?

November 25, 2008

Class Materials for Lecture 15

Brief Outline of Topics Covered in Lecture 13

Chapter 22 Aggregate Demand and Supply Analysis

  • Aggregate supply
    • Aggregate supply in the short-run
    • Aggregate supply in the long-run
  • Equilibrium
    • Does the economy self-correct?

Chapter 24 Money and Inflation

  • Inflation
    • Monetarist view
    • Keynesian view
    • Supply shocks
    • Always a monetary phenomena?
  • How does inflationary policy arise?
    • Cost push - demand for higher wages
    • Demand pull - shooting at the wrong target
  • Budget deficits and inflation

Materials from class:

Lecture13tab1a

Lecture13tab1b

Lecture13tab2

Lecture13fig5

Video:

Additional Reading:

Application:

James Kwak says the bailout is "Weak, Arbitrary, Incomprehensible." I think he has it right:

Citigroup Bailout: Weak, Arbitrary, Incomprehensible: According to the Wall Street Journal, the deal is done. Here are the terms. In short: (a) Citi gets another $27 billion on the same terms as the first $25 billion, except that the interest rate is now 8% instead of 5%, and there is a cap on dividends of $0.01 per share per quarter; and (b) the government (Treasury, FDIC, Fed) agrees to absorb 90% of losses above $29 billion on a $306 billion slice of Citi’s assets, made up of residential and commercial mortgage-backed securities. (If triggered, some of that guarantee will be provided as a loan from the Fed.) There is also a warrant to buy up to $2.7 billion worth of common stock (I presume) at a staggeringly silly price of $10.61 per share (Citi closed at $3.77 on Friday).

The government (should have) had two goals for this bailout.

Continue reading "Class Materials for Lecture 15" »

Homework #7

Economics 470
Fall 2008
Homework 7
Due Thursday, December 4

1. Show that the Fed cannot continuously hit both a money supply target and an interest rate target, i.e. that it must choose one or the other.

2. How would an increase in the riskiness of financial assets shift the AD curve? Use the IS-LM model to derive the result.

3. Why does the SRAS slope upward?

4. Explain debt monetization.

[Solution to Homework 7]

November 20, 2008

Class Materials for Lecture 14

Brief Outline of Topics Covered in Lecture 14

Chapter 21 Monetary and Fiscal Policy in the IS-LM Model

  • The Fed cannot control both i and M simultaneously
  • Poole's Pules
    • Unstable IS curve
    • Unstable LM curve
  • The IS-LM model in the long-run
    • Natural rate of output
    • Monetary and fiscal policy in the short-run and long-run
  • The aggregate demand curve
    • Derive from IS-LM model
    • Slope of aggregate demand curve
    • Shifts in the aggregate demand curve

Materials from class:

Ec470l121

Ec470l122

Ec470l123

Ec470l124

Ec470l125

Ec470l126

Video

Lecture 14 - YouTube
Lecture 14 - Google Video

Additional Reading:

Application:

FOMC Minutes Signal Fed Is Open to More Rate Cuts, WSJ: U.S. Federal Reserve officials stand ready to slash interest rates to levels not seen in half a century if the economic picture continues to worsen, minutes of their most recent policy meeting show. video Analyzing the Fed's Gloomy Outlook 2:53

CMC Markets' chief foreign exchange strategist Ashraf Laidi tells Dow Jones' Simon Constable what the Fed's minutes mean and why stocks won't be heading higher anytime soon. (Nov. 19)

Officials made clear that "unfolding economic developments" could require the Federal Open Market Committee "to further lower its target for the federal funds rate in the future and to review the adequacy of its liquidity facilities," the FOMC's Oct. 28-29 meeting minutes said.

Additionally, officials generally expected the economy to contract in the second half of 2008 and the first half of 2009, according to the minutes, which were released Wednesday after the customary three-week lag. (See the full text of the FOMC's minutes.)

Continue reading "Class Materials for Lecture 14" »

November 18, 2008

Midterm 2 Solution

Midterm 2 and solution.

November 14, 2008

Review Questions for Midterm 2

Review Questions for Midterm 2
Economics 470/570
Fall 2008

Definitions

Money multiplier
Corridor or Tunnel System
Quantity equation
Velocity of money
Equation of exchange
Consumption, disposable income, MPC and MPS
Investment
Government spending
Aggregate demand or expenditures
Expenditure multiplier
IS curve
LM curve
Policy effectiveness
Crowding out

Essay

1. Suppose that a bank has $100,000 in excess reserves that it loans out. Assuming that the required reserve ratio is 20%, use t-accounts to illustrate the multiple deposit creation process. Use this to obtain the simple deposit multiplier.

Chapter 14

2. Explain why the multiplier falls when people hold currency or when banks hold excess reserves.

3. Suppose that the required reserve ratio is 20%, the currency to deposit ratio is .25, the excess reserve to deposit ratio is .05, and the monetary base is 1,000. (a) Find the money supply. (b) Let open market operations increase the monetary base by 200. Use the money multiplier to find the new value of the money supply.

4. Explain how and why the money multiplier changes when (a) the required reserve ratio increases, (b) the currency to demand deposit ratio increases, and (c) the excess reserve to demand deposit ratio increases. Who determines each of these quantities?

Chapter 15

5. (a) Explain why the demand curve for reserves slopes downward. (b) Explain the shape of the supply curve for reserves.

6. Use the supply and demand model for bank reserves to explain and illustrate the effects of (a) an open market operation to buy bonds, (b) a decrease in the discount rate, and (c) an increase in required reserves.

7. Describe the three traditional tools available to the Fed for controlling the money supply.

8. What is meant by the phrase lender of last resort? Why is this important? Explain and show graphically how the Fed uses discount rate policy to act as a lender of last resort and how this limits the amount the federal funds rate can rise.

9. Explain the quantity theory of money. Explain the Cambridge approach and illustrate that it leads to the same identity as the quantity theory. What assumptions are imposed to arrive at a theoretical statement?

10. What is the money demand function in the classical model?

11. Discuss the transactions, precautionary, and speculative motives for holding money in Keynes liquidity preference theory. When all three motives are put together, what theory of money demand emerges?

12. Show the money demand curve graphically and explain why it slopes downward. Show how the money demand curve shifts when income increases.

13. According to Baumol, the transactions demand for money depends upon the interest rate as well as nominal income. Explain why the transactions demand for money depends upon the interest rate. Why is this important?

14. What did Tobin add to Keynes theory of the speculative demand for money? Why was this development important?

15. Explain Friedman's Modern Quantity Theory of the Demand for Money.

16. Derive the IS curve. Explain intuitively why it slopes downward. What factors cause the IS curve to shift? In what direction do they shift the IS curve?

17. Derive the LM curve. Explain intuitively why it slopes upward.  What factors cause the LM curve to shift? In what direction do they shift the LM curve?

18. Show graphically and explain intuitively how an increase in government spending affects income and the interest rate in the IS-LM model.

19. Show graphically and explain intuitively how an increase in the money supply affects income and the interest rate in the IS-LM model.

20. Explain why the LM curve is vertical when money demand is unaffected by changes in the interest rate (as in the classical model). Explain and show graphically why the LM curve is horizontal in a liquidity trap.

21. Use the IS-LM model to show that monetary policy becomes more effective relative to fiscal policy as money demand becomes less sensitive to the interest rate (examine the cases where the LM curve is either vertical or horizontal). Explain the result intuitively. What does this imply about the use of monetary and fiscal policy over the business cycle?

22. Explain why investment is less sensitive to interest rate changes in recessions as compared to when the economy is operating closer to full employment. Explain why the IS curve is vertical when investment is completely insensitive to changes in the interest rate.

23. Use the IS-LM model to show that fiscal policy becomes more effective relative to monetary policy as investment becomes less sensitive to the interest rate (examine the cases where the IS curve is either vertical or horizontal). Explain the result intuitively. What does this imply about the use of monetary and fiscal policy over the business cycle?

[Many of these are also homework problems]

November 13, 2008

Class Materials for Lecture 13

Brief Outline of Topics Covered in Lecture 13

Chapter 20 The IS-LM Model [cont.]

  • The LM Curve
    • Derive LM curve from money demand - money supply diagram
    • Shifts in the LM curve
    • Slope of the LM curve
    • The liquidity trap
            
  • Equilibrium
    • Stability of equilibrium

Chapter 21 Monetary and Fiscal Policy in the IS-LM Model

  • Changes in the equilibrium values of output and the interest rate
    • Monetary policy in the IS-LM model
    • Fiscal policy in the IS-LM model
  • Effectiveness of Monetary and Fiscal Policy Graphically and Intuitively
    • Responsiveness of money demand to the interest rate (including liquidity trap)
    • Responsiveness of investment to the interest rate

Video

Lecture 13 - YouTube
Lecture 13 - Google Video

Materials from class:

Lecture9fig2

Lecture10fig1

Lecture10fig2

Lecture10fig3

Lecture10fig4

Lecture10fig5

Lecture10fig6

Lecture10fig7

Additional Reading:

Application:

Tim Duy:

Misguided Policies, by Tim Duy: From the wires:

15:30 *PAULSON SAYS MARKET TURMOIL WON'T ABATE UNTIL HOUSING REBOUNDS

Such comments always leave me with a sick feeling in my stomach – if policymakers are waiting for the housing market to rebound, they had better be prepared for a long wait. Sort of liking waiting for the NASDAQ to revisit the 5,000 mark. I think the biggest potential for policy error lies in maintaining the delusion that preventing housing, and by extension, consumer spending, from adjusting is central to fixing the nation’s economy. Policy would be best focused on supporting the inevitable transition away from debt-supported consumer dependent growth dynamic.

Continue reading "Class Materials for Lecture 13" »

November 11, 2008

Class Materials for Lecture 12

Brief Outline of Topics Covered in Lecture 12

Chapter 20 The IS-LM Model [cont.]

  • The LM Curve
    • Derive LM curve from money demand - money supply diagram
    • Shifts in the LM curve
    • Slope of the LM curve
    • The liquidity trap

Lecture 12 - YouTube
Lecture 12 - Google Video

Additional Reading:

Application:

Tim Duy looks at monetary and fiscal policy options in light of an economy that continues to slide downhill:

Bad to Worse, by Tim Duy: From bad to worse is about the only way to describe the flow of data last week. With each new data point, the case for additional stimulus grows. But does the Fed have much room to maneuver before pursuing a significant shift in policy? And should we listen to those nagging concerns that the limits to US deficit spending are soon approaching?

Adding to the dismal manufacturing report early in the week, the ISM nonmanufacturing numbers confirmed what most suspected – the downturn has moved solidly into the service sector. The details were as weak as the headline, including a fresh drop in the employment measure. The latter set the stage for the weekly initial claims release, which unsurprisingly pointed to further deterioration in the labor market even as the jobless total climbed to the highest level in 25 years. The all important employment report only added to the gloom – a solid analysis from HBSC is available via Across the Curve, with more to read from Jim Hamilton. I would shy away from analysis that focuses on the relatively small percentage loss of employment, or minimize the consequences. From Justin Fox (hat tip Menzie Chinn):

The vast majority of workers remain employed--and will remain employed even if the recession deepens. Barring an unraveling of the financial system, they will eventually get back to spending at a healthier pace than in the scary month of October.

Justin Fox is apparently not worried about the economic consequences of having the U-6 broad measure of unemployment at 11.8%.

If the economy was still shedding jobs at less than 100k a month, and the losses were most sector specific, you could say that a relatively mild restructuring process was underway. That is no longer the case – the breadth and depth of payroll declines scream something much worse. Note also that these numbers are appearing closer to the beginning of the recession than at the end. It could and will get a lot worse before it gets better.

Continue reading "Class Materials for Lecture 12" »

November 08, 2008

Homework #6

Economics 470
Fall 2008
Homework 6
Due Thursday, November 13

1. Explain why (a) investment and the interest rate are inversely related, and (b) net exports and the interest rate are inversely related.

2. (a) Derive the IS curve from the 45 degree line diagram. (b) Use the 45 degree line diagram to show how the IS curve shifts when there is a decrease in taxes.

3. Derive the LM curve for the case where the economy contains a liquidity trap.

[Solution to Homework 6]

November 06, 2008

Class Materials for Lecture 11

Brief Outline of Topics Covered in Lecture 11

Chapter 20 The IS-LM Model

  • The IS curve
    • Investment and the interest rate
    • Net exports and the interest rate
    • Derive the IS curve from 45 degree line diagram
    • Shifts in the IS curve
    • Slope of IS curve

Video:

Lecture 11 - YouTube
Lecture 11 - Google Video

Additional Reading:

Application:

Fed Again Raises Rates It Pays on Reserves: The Federal Reserve released the following statement Wednesday.

The Federal Reserve Board on Wednesday announced that it will alter the formulas used to determine the interest rates paid to depository institutions on required reserve balances and excess reserve balances.

Previously, the rate on required reserve balances had been set at the average target federal funds rate established by the Federal Open Market Committee (FOMC) over a reserves maintenance period minus 10 basis points. The rate on excess balances had been set as the lowest federal funds rate target in effect during a reserve maintenance period minus 35 basis points. Under the new formulas, the rate on required reserve balances will be set equal to the average target federal funds rate over the reserve maintenance period. The rate on excess balances will be set equal to the lowest FOMC target rate in effect during the reserve maintenance period. These changes will become effective for the maintenance periods beginning Thursday, November 6.

The Board judged that these changes would help foster trading in the funds market at rates closer to the FOMC’s target federal funds rate.

November 05, 2008

Homework #5

Economics 470
Fall 2008
Homework 5
Due Tuesday, November 11

1. What is the money demand function in the classical model? How does the money demand function differ under the Cambridge approach? Why is this important?

2. Explain the speculative motive for holding money in Keynes liquidity preference theory and why, in aggregate it is negatively related to the interest rate.

3. Show the money demand curve graphically and explain why it slopes downward. Show how the money demand curve shifts when income increases. How does the money demand curve shift if there is an increase in the riskiness of financial assets?

4. What did Tobin add to Keynes theory of the speculative demand for money? Why was this development important?

Solution to Homework 5 (Google, YouTube):

November 04, 2008

Class Materials for Lecture 10

Brief Outline of Topics Covered in Lecture 10

Chapter 19 Money Demand

  • Further Developments in the Keynesian Approach
    • Why Transactions demand depends upon i (Baumol)
    • Tobin's Uncertainty Theory
  • Friedman’s Modern Quantity Theory of Money

Materials from class:

Lecture7fig2

Video:

Lecture 10 - YouTube
Lecture 10 - Google Video

Additional Reading:

Application:

Tim Duy responds to the latest set of "ugly numbers":

Ugly Numbers, by Tim Duy: For many months, this was the recession that wasn’t, as many key cyclical indicators refused to roll over as expected. That is no longer the case, as virtually all data is headed down at an almost blinding pace. Today’s ISM release is a perfect example; the headline number made a key move well below 50 in September, and extended that decline to 38.9 in October to the lowest level since 1983.

The details were even worse.

Continue reading "Class Materials for Lecture 10" »

November 03, 2008

Homework #4 Solution

The homework is here, and here is the solution.

October 30, 2008

Class Materials for Lecture 9

Brief Outline of Topics Covered in Lecture 9

Chapter 15 Tools of Monetary Policy

The Market for Reserves and the Federal Funds Rate

  • Tools of monetary policy: Open Market Operations, Discount Policy, and Reserve Requirements

Chapter 19 Money Demand

  • Quantity Theory of Money
    • Velocity of Money and Equation of Exchange
    • Quantity Theory
    • Quantity Theory of Money Demand
  • The Cambridge Approach
  • Is velocity a Constant?
  • Keynes’s Liquidity Preference Theory
    • Transactions Motive
    • Precautionary Motive
    • Speculative Motive
    • Putting the Three Motives Together

Materials from class:

Lecture7fig1

Video:

Lecture 9 [Google video] - Fall 2008
Lecture 9 [YouTube] - Fall 2008

Lecture 9

Additional Reading:

Application:

The Press Release from the Fed's FOMC meeting:

Press Release Release Date: October 29, 2008

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 1 percent.

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability.

Recent policy actions, including today’s rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, and San Francisco.

October 29, 2008

"Come With Me to the F.O.M.C.: A Sneak Peak Into Fed Life"

A look inside the FOMC:

Come With Me to the F.O.M.C.: A Sneak Peak Into Fed Life, by Bob McTeer, Economix:Bob McTeer is a former president of the Federal Reserve Bank of Dallas.

Today is the second day of a two-day Federal Open Market Committee meeting. The rate decision along with the accompanying verbiage will be released at 2:15 p.m. If I were still there, I’d go in with a tentative idea of how I would vote, but would try to keep an open mind during the presentations and discussions. Today, I would be inclined toward a half percentage point cut, from 1.50 to 1.00 percent.

I don’t think another rate cut is necessary nor even very helpful, but not cutting would roil financial markets, and the European Central Bank needs more pressure to catch up with another coordinated cut. I called for a coordinated rate cut on my other blog on Oct. 7, and they took me up on it on Oct. 8, between regular meetings. Coincidence?

One might argue that another Fed cut without being matched by the E.C.B. would weaken the dollar, but, given its rapid rise lately, I don’t think that would be a bad outcome. A too-sharp rise in the dollar would hurt the growth of our net exports, which has been our strongest sector.

Without a strong conviction, I would be inclined to go along with the chairman’s majority even if our views differed. Dissents should be used sparingly and only when they are a matter of strong conviction. Also, it’s important to support the chairman and present a united front during a crisis.

“Come With Me to the F.O.M.C.” was the title of a Richmond Fed pamphlet written long ago and updated by others. Its lasting popularity suggests an interest in what goes on behind the closed doors. While I’ve been retired from the Fed almost four years, it changes so slowly that I expect my memories aren’t far off.

Some F.O.M.C. Color

My almost 14 years as an F.O.M.C. member came with the presidency of the Federal Reserve Bank of Dallas from Feb. 1, 1991, to Nov. 4, 2004. Alan Greenspan was chairman during that time and then-Governor Bernanke sat next to me for almost three years. Reserve Bank presidents inherit their place around the table from their predecessors, and Dallas used to sit between St. Louis and Boston. For the first several years of my tenure, Alan Greenspan sat at the head of the long board table, but he announced one day that he was switching to the middle spot. That was a landmark event. We all rotated to keep our relative position, and I got the chairman’s former seat.

Since Chairman Greenspan didn’t normally conduct policy by the seat of his pants, as his successor has been accused of doing, his seat never made me feel smarter. The president of the Boston Fed decided about that time to move to the other end of the table — I don’t know what I did — so I ended up between Bill Poole of the St. Louis Fed and Governor Bernanke, the only two principals around the table with beards. Ben’s was trimmed pretty short, but Bill’s was kind of shaggy. It made my nose itch when I looked his way.

Two-day meetings like the one concluding today used to occur only twice a year — in February and July. Chairman Bernanke added more two-day meetings to the schedule. The July meeting was close to the Fourth, and the British ambassador always had us as dinner guests on the evening between meetings. Those dinners were nice, but they ran on too long. The vice chairman, Alice Rivlin, was the all-time champion at extricating us before midnight. The dialogue during the dinner between the chairman and the ambassador was an education for me — actually for us all — but I’m probably the only one to admit it.

Congress centralized power in Washington in the 1930s, and gave the coveted (in central bank world) title of governor to the seven-member Washington contingent and “demoted” the twelve former regional governors to “president.” It also reduced the number of “presidents” voting from 12 to 5 so Washington would have a 7 to 5 advantage if votes ever split along those lines. The New York Fed president, as vice chairman of the F.O.M.C., always has a vote; 4 of the other 11 regional bank presidents also have a vote, based on an annual rotation.

I mention the voting arrangement because it is often misunderstood. All the presidents participate fully in all the discussions, and an observer would be unable to tell the voters from the nonvoters until the vote at the end of the meeting. A persuasive nonvoting president would probably have more influence on the outcome than a non-persuasive voter.

F.O.M.C. members traditionally don’t discuss their votes or policy before the meeting. If the presidents got together for dinner the night before, they limited their discussion to Reserve Bank business and gossip. Usually they went their separate ways for dinner. Being the introvert that I am, I frequently had take-out Chinese food in my hotel room.

Everyone arrives for the meetings after having done tons of homework. The Reserve Banks have excellent research departments, but they are smaller and less specialized than the board’s research staff. The presidents are expected to say something about their regions, as well as the national and international economy. It’s a lot like cramming for finals. The board staff’s material, mostly contained in the “green book,” included all recent data in context, forecasts made under alternative assumptions, and special topics of current interest. It was always comprehensive and outstanding in quality.

The board staff also prepared a “blue book” with alternative policy choices and commentary. Forecasts based on the board’s econometric models were treated respectfully by everyone, but with a few grains of salt.

I once committed political incorrectness by not treating them respectfully enough. It was sometime during the boom of the late 1990s that I observed out loud that the staff’s growth forecast was usually a percentage point too low and that its inflation forecast was usually a percentage point too high. I announced that I derived my own forecast by moving that one percent from inflation to growth. The obvious truth of my statement only made it worse and added to the coolness of the breeze that came my way for some time after that.

The forecasts of high inflation, while actual inflation remained low, were the cause of my lone dissents in June and August 1999 against raising the target federal funds rate. Actual inflation was nil, but the models always had it right around the corner.

I probably made things worse by saying in speeches that my favorite economists were Yogi Berra and Richard Pryor: Yogi, for saying you can observe a lot just by watching, and Richard for famously asking, “Who are you going to believe — me or your own lying eyes?” Sometimes, I would also paraphrase Mae West and say “too much of a good thing is just about right,” referring, of course, to the booming economy.

These days, I’ll bet F.O.M.C. members really can’t believe their own lying eyes.

See also Come with Me to the FOMC, Remarks by Governor Laurence H. Meyer, Willamette University, Salem, Oregon April 2, 1998.

October 28, 2008

Class Materials for Lecture 8

Brief Outline of Topics Covered in Lecture 8

Chapter 15 Tools of Monetary Policy

The Market for Reserves and the Federal Funds Rate

  • Supply and Demand in the Market for Reserves
  • Tools of monetary policy: Open Market Operations, Discount Policy, and Reserve Requirements

Chapter 19 Money Demand

  • Quantity Theory of Money
    • Velocity of Money and Equation of Exchange
    • Quantity Theory
    • Quantity Theory of Money Demand
  • The Cambridge Approach
  • Is velocity a Constant?
  • Keynes’s Liquidity Preference Theory
    • Transactions Motive
    • Precautionary Motive
    • Speculative Motive
    • Putting the Three Motives Together
  • Further Developments in the Keynesian Approach

Materials from class:

None for today.

Video:

Lecture 8 [Google video] - Fall 2008


Lecture 8

Additional Reading:

Application:

Stephen Roach says the Fed needs to broaden its mandate:

Add ‘financial stability’ to the Fed’s mandate, by Stephen Roach, Commentary, NY Times: A regulatory backlash is under way as the US body politic comes to grips with the financial crisis. ... As Washington creates a new system, it must also redefine the role of the Federal Reserve.

Specifically, the US Congress needs to alter the Fed’s policy mandate to include an explicit reference to financial stability. The addition of those two words would force the Fed not only to aim at tempering the damage from asset bubbles but also to use its regulatory authority to promote sounder risk management practices. Such reforms are critical...

By focusing on financial stability, the Fed will need to adjust its tactics in two ways. Firstly, monetary policy will need to shift from the Greenspan-Bernanke reactive, post-bubble clean-up approach towards pre-emptive bubble avoidance. Second, the bank will need to be tougher in its neglected regulatory oversight capacity. ...

I am not suggesting the Fed develops numerical targets for asset markets. It should have discretion as to how it interprets the new mandate. Yes, it is tricky to judge when an asset class is in danger of forming a bubble. But hindsight offers little doubt of the bubbles that developed over the past decade – equities, residential property, credit and other risky assets. The Fed wrongly dismissed these developments, harbouring the illusion it could clean up any mess later. Today’s problems are a repudiation of that approach.

There is no room in a new financial stability mandate for bubble denialists such as Alan Greenspan.. He argued that equities were surging because of a new economy; that housing forms local not national bubbles and that the credit explosion was a by-product of the American genius of financial innovation. ... Under a financial stability mandate, the Fed will need to replace its ideological convictions with common sense. When investors buy assets in anticipation of future price increases the Fed will need to err on the side of caution and presume that a bubble is forming that could threaten financial stability.

The new mandate would also encourage the Fed to ... deploy... other tools. In times of asset-market froth, I favour the “leaning against the wind” approach with regard to interest rates – pushing the Federal funds rate higher than a narrow inflation target might suggest. But there are other Fed tools that can be directed at financial excesses – margin requirements for equity lending as well as controls on the issuance of exotic mortgage instruments... In addition, the Fed should not be bashful in using the bully pulpit of moral persuasion to warn against the impending dangers of asset bubbles.

Of equal importance is the need for the Fed to develop a clearer understanding of the linkage between financial stability and the open-ended explosion of derivatives and structured products. Over the past decade, an ideologically-driven Fed failed to make the distinction between financial engineering and innovation. It understood neither the products nor their scale, even as the notional value of global derivatives hit $516,000bn in mid-2007, the eve of the subprime crisis – up 2.3 times over the preceding three years to a level that was 10 times the size of world gross domestic product. The view in US central banking circles was that an innovations-based explosion of new financial instruments was a huge plus for market efficiency.

Driven by its ideological convictions, the Fed flew blind on the derivatives front. ... Like all crises, this one is a wake-up call. The Fed made policy blunders of historic proportions that must be avoided in the future. Adding financial stability to its mandate is vital to preventing such errors again.

To the extent that instability in the financial sector impacts employment and price stability, it's already part of the mandate. To the extent that it doesn't, why should the Fed care?

In any case, it's already implicitly part of the mandate, e.g. Mishkins says:

[T]he Federal Reserve's mandate is "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Because long-term interest rates can remain low only in a stable macroeconomic environment, these goals are often referred to as the dual mandate; that is, the Federal Reserve seeks to promote the two coequal objectives of maximum employment and price stability. ... (By the way, I wish that I could also discuss the Federal Reserve's role in promoting the stability of the financial system, another key objective of central banks, but unfortunately that would violate my own personal mandate of finishing this speech in the allotted time.)

Or, for a more explicit statement, see here.

The issue isn't whether preemption of bubbles falls under the Fed's mandate, it's whether a bubble-popping policy can help the Fed to achieve it's goals of maximum employment and stable prices. Greenspan advocated a clean up after the mess philosophy because he thought that preemption did more harm than good (the harm comes from popping misidentified bubbles due to very noisy information), but recent experience has led the Fed to reconsider this approach.

I think there's a broader issue here that's important. Popping the next bubble will take courage, the ability to hold steady in the face of severe criticism. It won't be as simple as raising interest rates, though that could help, it will require forceful action by the Fed on other fronts including communication with the public about why it's necessary to reduce the opportunities for people to make money during the boom. The Fed will need to explain why the action isn't choking off productive, innovative activity and that's not a message people will want to hear. If Greenspan had started announcing that he thought housing was overvalued and that people should think twice before purchasing a home, and then think again, the protests would have been heard far and wide. It wouldn't have been easy to do, and I can imagine congress objecting and asking the Fed to explain itself as an implicit threat to its independence. I think Roach is asking for more instutitonal support and guidance in taking such action so that it can be defended more easily as a group decision based upon pre-existing policy, it shouldn't be viewed as an ad hoc move by the Fed or the policy of a single individual. That's why the Fed's announcement that it will reconsider it's approach to bubbles is a good sign, it's a first step toward providing the institutional cover and guidance that will be needed to pursue such strategies.

October 23, 2008

Homework #4

Economics 470/570
Fall 2008
Homework #4
Due 10/30/2008

1. Suppose the Fed sells $1,000 worth of securities to the public. Assuming that the reserve requirement is 25%, use t-accounts to show the resulting multiple deposit contraction (carry the t-accounts out through three steps). Use the multiplier formula to calculate the total fall in bank deposits.

2. Derive the money multiplier when C0 and ER0. Explain why it is smaller than the simple money multiplier.

3. Show, using graphs, how (a) open market operations, (b) borrowing from the Fed, and (c) changes in reserve requirements affects the federal funds rate.

4. Show graphically how an increase in financial market risk impacts the federal funds rate, and how the Fed would respond in order to return the federal funds rate to its target value.

October 22, 2008

Class Materials for Lecture 7

Brief Outline of Topics Covered in Lecture 7

Chapter 14 Determinants of the Money Supply

  • Discount Loans
  • Overview of the Fed’s Ability to Control the Monetary Base

Multiple Deposit Creation: A Simple Model

  • Deposit Creation
  • Deriving the Formula for Multiple Deposit Creation
  • Critique of the Simple Model

The Money Supply Model and the Money Multiplier

  • Deriving the Money Multiplier

Factors That Determine the Money Multiplier

  • Changes in the Required Reserve Ratio, r
  • Changes in the Currency Ratio, c = C/D
  • Changes in the Excess Reserves Ratio, e = ER/D

Additional Factors That Determine the Money Supply

  • Changes in the Nonborrowed Monetary Base, MBn
  • Changes in Borrowed Reserves, BR, from the Fed

Chapter 15 Tools of Monetary Policy

The Market for Reserves and the Federal Funds Rate

  • Supply and Demand in the Market for Reserves

Materials from class:

Chalk only today.

Video:

Lecture 7 [Google video] - Fall 2008


Lecture 7

Additional Reading:

Application:

Struggling to Keep Up as the Crisis Raced On, NY Times: “I feel like Butch Cassidy and the Sundance Kid. Who are these guys that just keep coming?” — Treasury Secretary Henry Paulson Jr.

It was the weekend of Sept. 13, and the moment Treasury Secretary Henry M. Paulson Jr. had feared for months was finally upon him: Lehman Brothers was hurtling toward bankruptcy — fast.

Knowing that Lehman had billions of dollars in bad investments on its books, Mr. Paulson had long urged Lehman’s chief executive, Richard S. Fuld Jr., to find a solution for his firm’s problems. “He was asked to aggressively look for a buyer,” Mr. Paulson recalled in an interview.

But Lehman could not — despite what Mr. Paulson described as personal pleas to other firms to buy some of Lehman’s toxic assets and efforts to persuade another bank to acquire Lehman. With all options closed, he said, the government’s hands were tied. Although the Federal Reserve had helped bail out Bear Stearns — and was within days of bailing out the giant insurer American International Group — it could not help Lehman, even as its default threatened to wreak havoc on financial markets.

Continue reading "Class Materials for Lecture 7" »

October 21, 2008

Midterm 1 Solution

Midterm 1 and Solution.

October 18, 2008

Solution to Homework #3

Economics 470/570
Fall 2008
Solution to Homework #3

1. (a) Describe the structure and function of the Board of Governors of the Federal Reserve System. (b) Who is on the FOMC? What does the FOMC do?

(a) See the first part of the answer to question 3 in the essays and problems section (Part III - exam here).

(b) See the answer to question 3 in the short answer section (Part II - exam here).

2. How has the power structure of the Fed changed over time?

See the second part of the answer to question 3 in the essays and problems section (Part III - exam here).

3. How independent is the Fed? What factors contribute to independence? What factors work against independence? Discuss arguments for and against the independence of the Fed.

See the answer to question 2 in the essays and problems section (Part III - exam here).

October 17, 2008

Review Questions for Midterm 1

Review Questions for Midterm 1
Economics 470/570
Fall 2008

These are homework/review questions for the first exam which will be on Tuesday, October 21. The list is extensive - it covers all the topics we have covered in class that you are responsible for, so a thorough understanding of these questions is a good study guide for the exam.

Definitions

Financial Intermediary
Indirect finance
Direct finance
Financial Markets
Stocks and bonds
Medium of exchange/Double coincidence of wants
Unit of account/Multiplicity of prices
Store of value/Liquidity
Business cycle
Fully backed, fractionally backed, and fiat money
M1
FOMC
FAC
Discount window
Discount rate
Member bank
Type A, B, and C directors
Board of Governors
Beige book
Monetary base
Borrowed and Non-borrowed reserves
Federal funds rate
Margin requirement
Asset
Liability
Demand Deposit
Bank Reserves
Currency
Lender of Last Resort

Essay

Chapter 2

1. Suppose that there are 100 individuals, each with $1,000 in savings that they would like to lend. Suppose there are also 100 different people who want to take out $1,000 loans. Assuming an expected default rate of 10%, use this example to show how pooling risk through financial intermediation can increase the efficiency of financial markets.

2. Suppose that there are 100 individuals, each with $1,000 in savings that they would like to lend. Suppose there are 10 different people who want to take out $10,000 loans. Use this example to show how pooling small deposits through financial intermediation can increase the efficiency of financial markets.

3. Suppose that there are 100 individuals, each with $1,000 in savings that they would like to lend. However, in any given year 10% of them will need the money for emergencies. Because of this possibility, and the dire consequences if they cannot access their money at such a time, they are unwilling to lend the money for long periods of time. Explain how financial intermediation can solve this problem of "borrowing short and lending long" and increase the efficiency of financial markets.

4. Besides pooling risk, pooling small deposits, and pooling over time, what else do financial intermediaries do to increase the efficiency of financial markets?

5. Briefly, what does the phrase “increase the efficiency of financial markets” mean?

Chapter 3

6. What are the functions of money, i.e. why does money exist? Relative to a barter economy, what problems are overcome by the use of money?

7. To be useful as a medium of exchange, what properties should money have?

8. Describe the evolution of money from barter to fiat money. How did paper money arise?

9. How is money measured? Why is there more than one definition of the money supply? Are data on the money supply reliable?

Chapter 4

10. How do nominal interest rates, ex-ante real interest rates, and ex-post real interest rates differ? Of the two real rates, which is the most important for understanding economic decisions?

Chapter 12

11. Briefly describe the major functions of Federal Reserve district banks.

12. How do member banks differ from other banks? How did the difference change in 1980?

13. Who is on the FOMC? What does the FOMC do?

14. Describe the structure of Federal Reserve districts and Federal Reserve banks.

15. Describe the structure and function of the Board of Governors of the Federal Reserve System.

16. How has the power structure of the Federal Reserve System shifted over time?

17. How independent is the Fed? What factors contribute to independence? What factors work against independence? Discuss arguments for and against the independence of the Fed.

Chapter 13

18. Use t-accounts to show that the Fed can control the monetary base better than it can control either currency or reserves. What does this result tell us?

October 16, 2008

Class Materials for Lecture 6

Brief Outline of Topics Covered in Lecture 6

Chapter 13 Multiple Deposit Creation and the Money Supply Process

Four Players in the Money Supply Process

The Fed’s Balance Sheet

  • Liabilities
  • Assets

Control of the Monetary Base

  • Open Market Operations with Bank
  • Open Market Operations with an Individual and shifts between Currency and Deposits

Chapter 14 Determinants of the Money Supply

The Money Supply Model and the Money Multiplier

  • Deriving the Money Multiplier

Factors That Determine the Money Multiplier

  • Changes in the Required Reserve Ratio, r
  • Changes in the Currency Ratio, c = C/D
  • Changes in the Excess Reserves Ratio, e = ER/D

Additional Factors That Determine the Money Supply

  • Changes in the Nonborrowed Monetary Base, MBn
  • Changes in Borrowed Reserves, BR, from the Fed

Materials from class:

None for today

Video:

Lecture 6 [Google video] - Fall 2008

 
Lecture 6

Additional Reading:

Application:

Bernanke Weighs Limiting Consolidation, Asset Bubbles, by Craig Torres, Bloomberg: Federal Reserve Chairman Ben S. Bernanke said the central bank will consider discarding its long- standing aversion to interfering with asset-price bubbles and warned that the banking business may be concentrated in too few companies.

Officials should review how supervision and interest rates can minimize the ''dangerous phenomenon'' of bubbles in housing, stocks and other assets that risk bringing the financial system and economy down with them when they burst, Bernanke said.

''There is no doubt that as we emerge from the current crisis that we are all going to look very hard at that issue and what can be done about it,'' he told the Economic Club of New York in his broadest remarks on future regulatory changes since the credit crisis deepened last month.

Continue reading "Class Materials for Lecture 6" »

October 15, 2008

Solution to Homework #2

<p><p><p>HTML clipboard</p></p></p>

Economics 470/570
Fall 2008
Homework #2 Solution

1. You have been put in charge of selecting a new medium of exchange for the economy. Choose something to serve as money, and evaluate it in terms of the properties that a medium of exchange must satisfy in order to be useful.

I choose rocks. The properties are:

Easily standardized, easy to verify value: Standardization would be hard, most rocks are different sizes and it is hard o make them identical. If value is based on, say, weight, then verification shouldn't be too hard, but it would be cumbersome t have to weigh money with every transaction.

Widely accepted: This shouldn't be a problem as there is nothing particularly objectionable about a rock.

Divisible: To some extent, rocks can be broken into smaller pieces, but it might be hard to break off exactly the right size piece. Each one would be a little different.

Easy to carry: Rocks are dense. The weight and bulk would be a disadvantage.

Storable and durable: rocks do well here since they don't deteriorate very easily

2. What is meant by the term "fractionally backed currency"? How does fractionally backed currency come about?

The phrase means that there is more paper money circulating than there is gold and silver backing it (or whatever commodity backs the money. i.e. there is less of it in bank safes than there is paper money in circulation) .

This happens when bankers hold less than 100% reserves against deposits.

3. Briefly, how do nominal interest rates, ex-ante real interest rates, and ex-post real interest rates differ? Of the two real rates, which is the most important for understanding economic decisions?

nominal: i = r + πe, where r is the real interest rate and πe is the expected inflation rate.

The ex-ante real rate is: r = i - πe.

The ex-ante real rate is: rex = i - π.

Thus, the ex-ante real rate is set at the beginning of the loan, before tha actual rate of inflation is known, so it's the nominal rate minus the expected rate of inflation. The ex-post real rate is set after the loan is complete and is therefore the nominal interest rate minus the actual rate of inflation. The ex-ante real rate comes at teh beginning and expresses hwo well you expect to do, while the ex-post rate comes at the end and assesses how well you actually did.

Since the decision to take a loan or not is at the beginning, not the end of the loan, it is the ex-ante real rate, i.e. how well you expect to do, that governs economic behavior. Hence, the ex-ante real rate is more important economically.

4. Briefly describe the major functions of Federal Reserve district banks.

As we discussed in class, they are:

To clear checks. The district banks facilitate clearing checks betwen banks. They do this by moving money between the reserve accounts they hold for banks in the district.

To issue new currency, withdraw old. Each district is responsible for issuing and removing currency in it sdistrict. Each district issues its own currency.

To make discount loans within the district. They determine which banks can and canot take out loans from the Fed.

To examine member banks. They are responsible for making sure banks in their district follow the regulations they are subject to.

To collect data, evaluate business conditions within the district, and to do research on monetary policy. The district banks are an important sourc eof information about business conditions.

To evaluate proposed bank mergers in the district, If it results in oo much concentration, the merger is opposed.

To act as a liason between businesses and the Federal Reserve System. This is one of the main functions of the branch banks within ieach district. If they weren't serving his role, many would have been closed.

Solution to Homework #1

Economics 470/570
Fall 2008
Homework #1

1. Suppose that there are 100 individuals, each with $1,000 in savings that they would like to lend. Suppose there are also 100 different people who want to take out $1,000 loans. Assuming an expected default rate of 10%, use this example to show how pooling risk through financial intermediation can increase the efficiency of financial markets.

Suppose that the individuals with the savings to be lent out are risk averse. In particular, suppose that they are not willing to risk losing all of their savings, at least not at an interest rate anyone would be willing to pay. There might be some individuals who would take a chance anyway, but for the most part loan activity would be expected to be low. This is because (a) it would be hard for individuals to find each other, so matching borrowers and lenders is difficult, (b) individuals aren't experts at assessing credit risk, so when they meet some stranger in (a) will they be willing to lend them money? How do they find out if they are a good risk? And (c) even if these problems are solved, there still wouldn't be any loans because with a default rate of 10%, 10 of the 100 people will lose everything and that's not a risk they are willing to take.

Now suppose that there are intermediaries. Also suppose they make loans at 15%. Then, in this case, loans = (100)*($1,000) = $100,000. But not all of it is paid back. Subtract off defaults of 10%, i.e. subtract $10,000 leaving a payback of $90,000.

Next, add interest to the $90,000. Since 90 people pay back $150 in interest each, the interest return is $13,500, so the total amount paid back, with interest, is $103,500. Now divide this among the lenders, i.e. divide this by 100 to get $1,035 returned to each person who made a loan. Thus, instead of 10 people losing everything, everyone makes 3.5%.

Overall, then:

Without an intermediary:  Few, if any loans are made.

With an intermediary:  Risk falls, the chances of losing everything falls, so more loans are made. The increase in loans increases investment, which in turn increases output. Hence, the economy is more efficient with intermediaries than without (and the intermediaries may also lower default risk because of their expertise at assessing the credit worthiness of borrowers, an effect I did not include in the example).

2. Suppose that there are 100 individuals, each with $1,000 in savings that they would like to lend. Suppose there are 10 different people who want to take out $10,000 loans. Use this example to show how pooling small deposits through financial intermediation can increase the efficiency of financial markets.

In this case, in order for loans to be made without an intermediary, 10 people have to find each other, then find someone who wants to borrow money, then find a way to assess their credit worthiness, draw up legal documents, etc. Thus, the transactions costs are high in this case, default risk might be high, and that would stifle loans reducing investment and output.

With an intermediary, these problems can be solved. The intermediary collects deposits, pools them together, and then loans the money to worthy borrowers using pre-existing contracts, etc. Since everyone can find the intermediary, the problem of borrowers and lenders finding each other is resolved, the intermediary is an expert at assessing risk so it can reduce default risk, and it can exploit economies of scale to draw up legal documents, etc. Because the costs are and default risk are lower when an intermediary is involved, more loans are made and output is higher. Hence, it's more efficient.

3. Suppose that there are 100 individuals, each with $1,000 in savings that they would like to lend. However, in any given year 10% of them will need the money for emergencies. Because of this possibility, and the dire consequences if they cannot access their money at such a time, they are unwilling to lend the money for long periods of time. Explain how financial intermediation can solve this problem of "borrowing short and lending long" and increase the efficiency of financial markets.

This is a case of matching short-term deposits with long-term loans. Suppose that borrowers want to take out 30 year loans, but no individual lender is willing to tie their money up for longer than a year. In this case, without an intermediary, productive loans would not get made since nobody can part with their money for so long.

But an intermediary solves this problem by replacing the people who take out their funds with new depositors (think of a university town where a quarter of the people leave each year, but are replaced with new students). Even though the money of individual depositors rolls over fairly fast relative to the length of the loan, the intermediary has a constant pool of funds on hand, and that allows it to make the loans. Since these are loans that wouldn't get made otherwise, and since loans turn into productive investment and lift output, having an intermediary involved increases efficiency.

4. Besides pooling risk, pooling small deposits, and pooling over time, what else do financial intermediaries do to increase the efficiency of financial markets?

I've already discussed these above, so I will simply list them here. Basically, intermediaries lower transactions costs and default risk. That is, they lower transactions costs by lowering search costs (borrowers and lenders finding each other), by lowering the costs of drawing up contracts and other documents (they pay once for a general contract, then spread the cost over many, many loans), and through having the means and knowledge to check the credit worthiness of borrowers (they do it faster and cheaper). And, by using their accumulated expertise at checking credit worthiness, they lower default rates.

5. Briefly, what does the phrase “increase the efficiency of financial markets” mean?

The phrase means that, with the same amount of resources in the economy, output will be higher with intermediaries than without. Intermediaries help us to use the existing stock of resources more efficiently (by making it possible for productive loans to be made that would otherwise not occur they increase investment and output.)

October 14, 2008

Class Materials for Lecture 5

Brief Outline of Topics Covered in Lecture 5

Chapter 12 Structure of Central Banks and the Federal Reserve System

Origins of the Federal Reserve System

  • Distribute power to geographic regions, the public sector, the private sector, the business sector, and the financial sector

Formal Structure of the Federal Reserve System

  • Federal Reserve Banks
  • Member Banks
  • Board of Governors of the Federal Reserve System
  • Federal Open Market Committee (FOMC)
  • The Federal Advisory Council (FAC)

Informal Structure of the Federal Reserve System

  • How Power Has Been Centralized Over Time

How Independent is the Fed?

Should The Fed Be Independent?

  • The Case for Independence
  • The Case Against Independence

Homeworks 1 and 2 due at end of class.

Materials from class:

The Federal Reserve Board eagle logo links to home page

The Twelve Federal Reserve Districts
Addresses and
phone numbers
Banks
Branches

Boston
New York
Philadelphia
Cleveland
Richmond
Atlanta
Chicago
St. Louis
Minneapolis
Kansas City
Dallas
San Francisco
Board
Image map of the United States with links to websites of the Federal Reserve Districts

First District: BostonSecond District: New YorkThird District: PhiladelphiaFourth District: ClevelandBoard of GovernorsBoard of GovernorsFifth District: RichmondSixth District: AtlantaSeventh District: ChicagoEighth District: St. LouisNinth District: MinneapolisTenth District: Kansas CityEleventh District: DallasTwelfth District: San FranciscoTwelfth District: San Francisco



Central Bank Independence and Inflation

From "Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence," by Alberto Alesina and Lawrence H. Summers, Journal of Money, Credit and Banking, Vol. 25, No. 2. (May, 1993), pp. 151-162  (the link will work on UO net, but I don't expect you to read the paper as it is a bit technical):

This has changed with the adoption of inflation targeting by central banks. Note also that Adam Posen casts doubt on whether causality runs from central bank independence to improved macroeconomic performance in Central Bank Independence and Disinflationary Credibility: A Missing Link?, NY Fed Staff Report, May 1995.

Video:

Lecture 5 [Google video] - Fall 2008


Lecture 5

Additional Reading:

Application:

U.S. Investing $250 Billion in Banks, NY Times: The Treasury Department, in its boldest move yet, is expected to announce a plan on Tuesday to invest up to $250 billion in banks... The United States is also expected to guarantee new debt issued by banks for three years — a measure meant to encourage the banks to resume lending to one another and to customers...

And the Federal Deposit Insurance Corporation will offer an unlimited guarantee on bank deposits in accounts that do not bear interest — typically those of businesses...

Rescue

Continue reading "Class Materials for Lecture 5" »

October 12, 2008

Homework #3

Homework #3
Due 10/16 (Thursday) at the end of class

<p><p><p>HTML clipboard</p></p></p>

1. (a) Describe the structure and function of the Board of Governors of the Federal Reserve System. (b) Who is on the FOMC? What does the FOMC do?

2. How has the power structure of the Fed changed over time?

3. How independent is the Fed? What factors contribute to independence? What factors work against independence? Discuss arguments for and against the independence of the Fed.

October 09, 2008

Class Materials for Lecture 4

Brief Outline of Topics Covered in Lecture 4

Chapter 3 What is Money? [continued...]

Evolution of the Payments System [finish this section]

Commodity Money
Partially backed paper money
Full backed paper money
Fiat Money

Measuring Money

The Federal Reserve’s Monetary Aggregates

How Reliable Are the Money Data?

Chapter 5 The Behavior of Interest Rates [pages 87-90]

The Distinction between Real and Nominal Interest Rates

Nominal interest rates
Ex-ante real rates
Ex-post real rates

Chapter 12 Structure of Central Banks and the Federal Reserve System

Origins of the Federal Reserve System

  • Distribute power to geographic regions, the public sector, the private sector, the business sector, and the financial sector

Formal Structure of the Federal Reserve System

  • Federal Reserve Banks
  • [cont. next time...]

Materials from class:

Lecture2fig1

Lecture2fig2

Video:

Lecture 4 [Google video] - Fall 2008


Lecture 4

Additional Reading:

Application:

U.S. May Take Ownership Stake in Banks, NYT: Having tried without success to unlock frozen credit markets, the Treasury Department is considering taking ownership stakes in many United States banks to try to restore confidence in the financial system, according to government officials.

Treasury officials say the just-passed $700 billion bailout bill gives them the authority to inject cash directly into banks that request it. Such a move would quickly strengthen banks’ balance sheets and, officials hope, persuade them to resume lending. In return, the law gives the Treasury the right to take ownership positions in banks, including healthy ones.

The Treasury plan was still preliminary and it was unclear how the process would work, but it appeared that it would be voluntary for banks.

Continue reading "Class Materials for Lecture 4" »

October 08, 2008

Homework #2

Homework #2
Due 10/14 at the end of class
(same due date as homework #1)

1. You have been put in charge of selecting a new medium of exchange for the economy. Choose something to serve as money, and evaluate it in terms of the properties that a medium of exchange must satisfy in order to be useful.

2. What is meant by the term "fractionally backed currency"? How does fractionally backed currency come about?

3. Briefly, how do nominal interest rates, ex-ante real interest rates, and ex-post real interest rates differ? Of the two real rates, which is the most important for understanding economic decisions?

4. Briefly describe the major functions of Federal Reserve district banks.

October 07, 2008

Fed Watch: Where Is The Rate Cut?

Tim Duy says the Fed may not cut the target interest rate at its next rate setting meeting:

Where Is The Rate Cut?, by Tim Duy: On the surface, the case for a rate cut seems obvious. But, despite an extraordinary and historic two weeks on Wall Street, Bernanke & Co. have failed to deliver. And perhaps the lack of action today, a day of panic in global equity markets, is telling us something about policy – don’t look for a rate cut, at least not yet. Maybe we should be listening.

If there is one thing the Fed has taught us in the last year, it is that they are inclined to meet periods of financial turbulence with a rate cut. Hence growing expectation for a rate cut, expectations that were only heightened by the string of data that confirmed for almost all remaining doubters that the US economy had slid into recession by at least the third quarter, if not much earlier. Last week’s employment and ISM reports for September appeared to seal the deal on that call.

Relatively dovish Fed-speak appeared to confirm these expectations. And if a rate cut was coming, why wait until the end of the month, especially when equity markets needed a boost of confidence? Yet no rate cut emerged. Instead, some Fed speakers have come out against a rate cut, such as St. Louis Fed President James Bullard and Richmond Fed President Jeffrey Lacker. To be sure, perhaps they are simply out of step with the Board. But perhaps the Fed has come to the conclusion that, at least for now, interest rates are not the problem, especially since, relative to the rate of decline in the real economy, the Fed is well ahead of where it would normally be at this point in the cycle.

Continue reading "Fed Watch: Where Is The Rate Cut?" »

October 06, 2008

Class Materials for Lecture 3

<p><p><p><p><p><p><p>New Page 3</p></p></p></p></p></p></p>

Brief Outline of Topics Covered in Lecture 3

Chapter 1 Why Study Money, Banking, and Financial Markets? [continued]

Why Study Financial Markets?

Bond Market
Stock Market
Foreign Exchange Market

Chapter 3 What is Money? [pages 49-52]

Meaning of Money
Functions of Money

Medium of Exchange
Unit of Account
Store of Value

Evolution of the Payments System

Commodity Money
Partially backed paper money
Full backed paper money
Fiat Money

Measuring Money

The Federal Reserve’s Monetary Aggregates

How Reliable Are the Money Data?

Chapter 5 The Behavior of Interest Rates [pages 87-90]

The Distinction between Real and Nominal Interest Rates

Nominal interest rates
Ex-ante real rates
Ex-post real rates

Materials from class:

Lecture2fig1

Lecture2fig2

Video:

Lecture 3 [Google video] - Fall 2008


Lecture 3

Additional Reading:

Application: The Fed started paying interest on reserves:

FAQs about Interest on Reserves and the Implementation of Monetary Policy

1.How will the payment of interest on reserve balances be administered?

Detailed answers to questions about how the payment of interest on reserve balances will be administered and interest payments calculated can be found on the the Federal Reserve System Reporting and Reserves website.

What’s most critical for the implementation of monetary policy is that interest will be paid on the excess balances depository institutions hold, i.e., the amount above the quantity of balances needed to satisfy their reserve requirements (which will also be remunerated), and their clearing balances (which will continue to earn implicit interest in the form of earnings credits).

Continue reading "Class Materials for Lecture 3" »

October 04, 2008

Homework #1

Economics 470/570
Fall 2008
Due: End of class on 10/14

Homework #1

1. Suppose that there are 100 individuals, each with $1,000 in savings that they would like to lend. Suppose there are also 100 different people who want to take out $1,000 loans. Assuming an expected default rate of 10%, use this example to show how pooling risk through financial intermediation can increase the efficiency of financial markets.

2. Suppose that there are 100 individuals, each with $1,000 in savings that they would like to lend. Suppose there are 10 different people who want to take out $10,000 loans. Use this example to show how pooling small deposits through financial intermediation can increase the efficiency of financial markets.

3. Suppose that there are 100 individuals, each with $1,000 in savings that they would like to lend. However, in any given year 10% of them will need the money for emergencies. Because of this possibility, and the dire consequences if they cannot access their money at such a time, they are unwilling to lend the money for long periods of time. Explain how financial intermediation can solve this problem of "borrowing short and lending long" and increase the efficiency of financial markets.

4. Besides pooling risk, pooling small deposits, and pooling over time, what else do financial intermediaries do to increase the efficiency of financial markets?

5. Briefly, what does the phrase “increase the efficiency of financial markets” mean?

October 01, 2008

Class Materials for Lecture 2

Brief Outline of Topics Covered in Lecture 2

Since we talked about the financial crisis last time, the class materials will be the same as for Lecture 1.

Video:

Lecture 2 [Google video] - Fall 2008


Lecture 2

Additional Reading:

Application:

<p><p><p><p><p>HTML clipboard</p></p></p></p></p>

Tim Duy says "the Federal Reserve is inching closer to lower interest rates":

Rate Cuts Increasingly Likely, by Tim Duy: This week’s data flow only confirms what was apparent last week – the US economy deteriorated as we headed into the third quarter. By now, there should be no doubt that the US consumer is devoid of resources to further propel spending. And without an active consumer, the US economy will undoubtedly stagnate, especially since the rest of the world appears equally reliant on the US consumer. Such persistent weakness would traditionally prompt additional rate cuts on the part of the Federal Reserve, but I suspect interest rate policy has largely lost effectiveness. Starting with the mortgage meltdown that began last year, credit channels have become increasingly impaired despite aggressive rate cuts. The credit explosion of this decade has proven unsustainable; you cannot borrow your way to prosperity. The US economy is undergoing a structural adjustment that the Fed can only cushion, not stop.

Monday brought the personal income and expenditure report for August, which indicated that consumption expenditures will be negative in Q3 for the first time since 1991, a point pounced upon by commentators (here and here). Interestingly, private wage and salary growth continued to defy gravity:

Continue reading "Class Materials for Lecture 2" »

September 29, 2008

Class Materials for Lecture 1

Brief Outline of Topics Covered in Lecture 1

Chapter 1 Why Study Money, Banking, and Financial Markets?

Why Study Money and Monetary Policy?

Money and Business Cycles
Money and Inflation
Money and Interest Rates
Conduct of Monetary Policy
Fiscal Policy and Monetary Policy

Why Study Banking and Financial Institutions?

What Defines Banks and Financial Institutions?
What is Financial Intermediation?
Direct versus Indirect Finance
Why is Financial Intermediation Important?

Why Study Financial Markets?

Bond Market
Stock Market
Foreign Exchange Market

Chapter 2 An Overview of the Financial System (pgs 23-26, 35-37)

Functions of Financial Markets

Direct versus Indirect Finance

Structure of Financial Markets

Function of Financial Intermediaries

Chapter 3 What is Money? [pages 49-52]

Meaning of Money
Functions of Money

Medium of Exchange
Unit of Account
Store of Value

Materials from class:

Lecture1fig1
Lecture1fig2
Lecture1fig3
Lecture1fig7
Lecture1fig6

Video:

Lecture 1 [Google video] - Fall 2008


Lecture 1

Application:

Mark Thoma, Guest opinion, Oregonian, Sept. 19, 2008: Many people associate the onset of the Great Depression with the stock market crash in October 1929. But a more important cause was a series of banking panics in the years prior to the Great Depression, and the particularly severe banking collapse from 1930-1933.

Continue reading "Class Materials for Lecture 1" »

September 28, 2008

Course materials for Fall 2007

Link to course materials for Fall 2007.

(Links to other quarters are on the sidebar.)


  • Google

      
    Web This Site

Economics 470


  • Mark Thoma

    Office: PLC 471
    Phone: 346-4673
    Office Hours: T/Th
    2:00-3:00 p.m. and by appointment

    Web Page
    Email

    Economist's View Blog

    Department of Economics
    University of Oregon 1285
    Eugene, OR 97403-1285

GTF Info - 470


  • GTF: Isaac Swensen
    Office: PLC 507
    Email: isaac@uoregon.edu
    Office Hours: M-W 3:30-4:30 and by appointment

Economist's View