Economics 470/570 - Monetary Theory and Policy

Syllabus for Summer 2006

[Syllabus in pdf format]

Monetary Theory and Policy
Course: Economics 470/570
Professor: Mark Thoma
Office/Hours: PLC 471 on T/W/Th 10:00-11:00 a.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, 7th edition (Addison Wesley: New York).

Prerequisites: Economics 313 or the equivalent.

GTF, Office Hours, Location, and Email Address:

To be announced on web site

Tests and Grading: There will be two midterm exams and a final.  The midterms will be given Tuesday, August 1^st and Wednesday, August 9^th.  The final will be given on Thursday, August 17^th from 10:15 a.m. – 12:15 p.m.  No make-up exams will be given.  Each midterm is worth 30% and the final is worth 40%.  Grades will be assigned according to your relative standing in the class.

Homework: Problem sets will be assigned periodically. These are not graded, but it is strongly recommended that you do them since exam questions will be based, in part, upon the problem sets.

Course Outline:

Introduction	Mishkin Text
Introduction	Ch. 1, pgs. 8-13
The Role of Money in the Macroeconomy	Ch. 3, Ch. 4 pgs. 79-82
Central Banking and the Conduct of Monetary Policy
Structure of Central Banks and the Federal Reserve System	Ch. 14
Bank Reserves and the Money Supply	Ch. 15
Determinants of the Money Supply	Ch. 16
Tools of Monetary Policy	Ch. 17
Monetary Theory
The Demand for Money	Ch. 22
The Keynesian Framework	Ch. 23
Monetary and Fiscal Policy	Ch. 24
The AS-AD Model	Ch. 25
Money and Inflation	Ch. 27
Rational Expectations: Theory and Policy Implications	Ch. 28

Video Lectures - Summer 2006

Lecture 1 - Chapter 1, pgs. 8-13; Chapter 3, pgs. 49-52

Lecture 1
Google Video

Lecture 2 - Chapter 3, pgs. 53-61; Chapter 4, pgs. 87-90

Lecture 2
Google Video

Lecture 3 - Chapter 12,  pgs. 311-321

Lecture 3
Google Video

Lecture 4 - Chapter 12,  pgs. 321-330; Chapter 13, pgs. 333-340

Lecture 4
Google Video

Lecture 5 - Chapter 13,  pgs. 340-347

Lecture 5
Google Video

Lecture 6 - Chapter 14,  pgs. 351-367; Chapter 15, pgs. 373-389

Lecture 6
Google Video

Lecture 7 - Chapter 19,  pgs. 493-500

Lecture 7
Google Video

Lecture 8 - Chapter 19,  pgs. 501-510

Lecture 8
Google Video

Lecture 9 - Chapter 20,  pgs. 513-531

Lecture 9
Google Video

Lecture 10 - Chapter 20, pgs. 531-535; Chapter 21, pgs. 539-546

Lecture 10
Google Video

Lecture 11 - Chapter 20, pgs. 546-549

Lecture 11
Google Video

Lecture 12 - Chapter 20, pgs. 549-558

Lecture 12
Google Video

Lecture 13 - Chapter 22, pgs. 561-568

Lecture 13
Google Video

Lecture 14 - Chapter 22, pgs. 569-580; Chapter 24, pgs 613-626

Lecture 14
Google Video

Lecture 15 - Chapter 24, pgs. 626-635; Chapter 25, 639-641

Lecture 15
Google Video

Lecture 16 - Chapter 25, pgs. 641-652

Lecture 16
Google Video

Lecture 17 - Chapter 25, pgs. 652-658

Lecture 17
Google Video

Midterm 2 Solution

Midterm 2

Midterm 2 solution

Midterm1 Solution

Midterm 1

Midterm 1 solution

Review Questions - Material after Midterm 2

Definitions

Potential or natural rate of output
Short-run and long-run in AD/AS model
Deficit
Debt
Debt monetization
Inflation
Activist/non-activist
Data lag
Recognition lag
Legislative lag
Implementation lag
Effectiveness lag
Policy ineffectiveness proposition
Rational expectations
Natural rate hypothesis

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. Explain the Monetarist view of aggregate demand. Explain why Monetarists do not believe that shifts in the IS curve affect aggregate demand.

6. Explain the Keynesian view of aggregate demand.

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

8. Is the economy self-correcting?

9. What causes the SRAS curve to shift? Explain.

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

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

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

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

14. Can budget deficits lead to inflation? Explain.

15. Why might governments choose to monetize the debt?

16. Explain the activist and non-activist positions on the use of government policy to stabilize macroeconomic variables such as real output. What problems are encountered in the pursuit of activist policies?

[8/16/06 - omit this question] 17. Explain and give an example of the Lucas critique. Why is this important?

18. What are the essential differences between the Classical, Keynesian, New Classical, and New Keynesian models?

19. Show that it is possible in a model with expectations (e.g. using the New Classical model) for an increase in the money supply to reduce output if the change in the money supply is smaller than expected.

20. 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.

21. 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.

[8/16/06 - omit this question] 22. Suppose the monetary authority wants to reduce the 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?

Review Questions - Midterm 2

Definitions

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

Essay

1. 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?

2. Is velocity a constant in Keynes liquidity preference theory? When actual data is examined, does velocity appear to be a constant? Why is this important?

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

4. 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?

5. Show the money demand curve graphically. Show how the money demand curve shifts when income increases.

6. 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?

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

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

9. What is the 45 degree line diagram? What is the expenditure multiplier?

10. What is the slope of the expenditure function? What factors cause the expenditure function to shift?

11. Derive the IS curve. Explain intuitively why it slopes downward.

12. Derive the LM curve. Explain intuitively why it slopes upward.

13. What factors cause the IS curve to shift? In what direction do they shift the IS curve?

14. What factors cause the LM curve to shift? In what direction do they shift the LM curve?

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

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

17. Explain why the LM curve is vertical when money demand is unaffected by changes in the interest rate (as in the classical model).

18. 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. Explain the result intuitively.

19. 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. 

20. 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. Explain the result intuitively. What does this imply about the use of monetary and fiscal policy over the business cycle?

Review Questions - Midterm 1

Definitions

Medium of exchange/Double coincidence of wants
Unit of account/Multiplicity of prices
Store of value/Liquidity
Liquidity
FOMC
FAC
Discount window
Discount rate
Member bank
Board of Governors
Monetary base
Borrowed and Non-borrowed reserves
Federal funds rate
Asset
Liability
Demand Deposit
Bank Reserves
Reserve Requirement
Required Reserves
Excess Reserves
Currency
Lender of Last Resort
Money multiplier
Dynamic and defensive open-market operations
Primary, secondary, and seasonal credit

Essay

1. How is money measured? Why is there more than one definition of the money supply?

2. 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?

3. Describe the evolution of money from barter to fiat money.

4. How do nominal interest rates, ex-ante real interest rates, and ex-post real interest rates differ?

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

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

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

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

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

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

11. 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.

12. Write down the government budget constraint and explain each term.

13. Why is a demand deposit an asset for an individual, but a liability of the bank?

14. 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?

15. Suppose that a bank has $100,000 in excess reserves. 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.

16. Suppose that the required reserve ratio is 20%, 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.

17. Derive the money multiplier when people hold currency and when banks hold excess reserves. Is the multipliers larger or smaller than the simple money multiplier, i.e. when currency held and excess reserves are both zero? Explain.

18. 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.

19. 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?

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

21. 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.

22. Describe the three tools available to the Fed for controlling the money supply. How do defensive and dynamic open-market operations differ? How do primary, seasonal, and secondary credit differ? What are the advantages of open-market operations relative to the other tools?

23. 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.

Fed Watch: Inflation Concerns Set to Trump the Slowdown?

Tim Duy with a Fed Watch in anticipation of next week's meeting [originally here]:

Inflation Concerns set to Trump the Slowdown?, by Tim Duy: The intensity of disgust for the 2Q06 GDP report – documented excessively at macroblog – caught me somewhat by surprise. It probably caught the Fed by surprise, too. After all, looking at the longer term, it is hard to see a reason to panic just yet:

We should all remember that plenty of people were ready to call it quits for the current expansion after the 4Q05 GDP report, but the economy (or, more accurately, the data) rebounded strongly the following quarter. Now, I doubt we are headed for another rebound of that magnitude – there is little reason to suspect that the consumer is gaining much additional traction. But the incoming data since I last wrote are, from the Fed’s perspective, relatively more supportive of an additional rate hike than not.

As far as the GDP report is concerned, it is consistent with the Fed expectation that the economy is slowing toward potential growth, with that slowing largely driven by changes in consumption spending and residential construction. I tend to believe they will discount the most worrisome part of the report, the 1% contraction in spending on equipment and software. They will view it as largely inconsistent with higher frequency data, notably the durable goods numbers, industrial production, and the ISM report. This is not to say the investment data in the GDP report are wrong (generally, the “data are wrong” story is an unwillingness to accept reality). Instead, there can be considerable volatility in the data that masks the underlying trend. Again, look back to 4Q05. There was hand-wringing over the weak investment numbers, only to see that story reversed in 1Q06. Moreover, the Fed will refer back to the Beige Book for supportive anecdotal evidence, noting:

Among products, demand was especially vigorous for various durable goods. Substantial sales gains were reported for makers of electrical equipment and information technology products such as semiconductors, along with further increases in orders and activity for makers of commercial aircraft and products used for national defense. The reports also pointed to a further rise in demand for makers of heavy equipment, machine tools, and steel, offset in part by reduced demand for smaller equipment that is oriented towards residential construction activity.

In short, I doubt the FOMC will see an impending recession in the GDP data. What they will find in recent data is the suggestion that inflation is becoming increasingly more entrenched. Core PCE inflation in June stood at 2.4% compared to a year ago, and 2.8% annualized compared to 3 months ago. Ouch – any way you slice it, the inflation news is unsettling, running well above the supposed 2% comfort level. And, the Fed will note, wages and salaries continue to climb:

One way to look at this is that consumers are merely demanding sufficient compensation to maintain living standards. The Fed will likely take a different tack – higher wage and salary growth suggests plenty of labor market pressure. Moreover, if higher prices are matched with higher wages, doesn’t that imply that imply that inflation expectations are set to be notched higher? Further supporting the wage/inflation story is the higher than expected ECI numbers. And note that oil breached $76 today, threatening to make a fresh attempt at the previous record. The long awaited stabilization of oil prices looks still to be long awaited.

And while household spending has eased, the Fed does not want households to maintain the rate of spending growth they became accustomed to in recent years anyway; I suspect FOMC members are quite pleased to see consumption spending pull back, and won’t be interested in reversing that process by accommodating higher prices. Yes, some sectors, maybe autos, will be hurt, but any rebalancing of the economy is going to result in some unpleasantness.

The truth is, the more I look at the data, the more I am tilted toward another Fed hike next week (not unlike William Polley). Financial markets, however, are not particularly supportive of that call – the focus of the markets has shifted from inflation to slow growth. Indeed, the predominant view appears to be the next rate hike is the last. Looking at the data, I simply can’t believe this is the thinking on Constitution Ave. And, as reported by David Altig, we have heard from two Fed officials who don’t sound so convinced a pause is a sure thing, with fairly balanced remarks consistent with Fed Chairman Ben Bernanke’s recent testimony on Capitol Hill.

Where then is the case for a pause? It can be largely summarized as:

1. The Fed’s new communication strategy continues to emphasize the expected slowdown.
2. Housing is slowing, and there is considerable amount of uncertainty regarding the ultimate economic impact. The only thing we know for sure is that it won’t be pretty. It is reasonable to expect the Fed to at least slowdown the pace of rate hikes in response.
3. Likewise, the economy does appear to be slowing in line with the Fed’s forecast, maybe even more quickly, depending how you want to read the GDP report. If the economy slows, won’t inflationary pressures ease as well?
4. The view that the inflation data is tainted by aberrant owner occupied rent behavior, and thus can be discounted. See my piece last week. With the OER question eliminated, the remaining inflation can be written off as pass-through from last summer’s energy price spike. Moreover, high productivity costs will contain inflation; note the low unit labor cost growth.

If the slowdown story is the important story on Constitution Ave., then much of the incoming data is supportive of a pause next month, especially because Fed officials continue to trot out the forecast for slowing growth. Overall, as I argued last time, the Beige Book appears consistent with that story. The data on economic activity, however, are sufficiently strong to prevent the Fed from believing a pause means done.

If the inflation numbers dominate, then we have to be looking at another rate hike next week. Yes, the inflationary pressures in the Beige Book looked pretty benign, but the actual PCE inflation data is simply not pretty. Will FOMC members want to look like they are disinterested observers in the face of these numbers? It’s one thing to let inflation creep up when the economy is clearly set to run below trend. But with the economy only expected to slow to potential, it becomes likely that the more inflation-wary policymakers will start thinking that they need to pull growth BELOW potential to reverse the inflationary uptick. That would be a whole new ballgame.

In short, I want to believe the “growth slowdown means a pause” story, but the inflation numbers keep circling around me like a pack of hyenas just waiting for me to drop my guard. Central bankers tend to hold onto hawkish leanings longer than expected. I simply suspect that while financial markets appear to be more focused on the slowdown story, the Fed will focus on the inflation story. Moreover, I doubt the Fed finds the GDP report to be particularly dismal. Consequently, I think the call is much closer than the betting on Wall Street indicates, close enough for me to expect another hike next week.

Perhaps tomorrow’s employment report will help lift the cloud…