Economics 470/570 - Monetary Theory and Policy

Review Questions for Exam

Economics 470/570
Winter 2006
Review Questions for Exam
[PDF FILE]

Definitions

Medium of exchange/Double coincidence of wants
Unit of account/Multiplicity of prices
Store of value/Liquidity
Financial intermediary
Direct and indirect finance
Liquidity
FOMC
FAC
Discount window
Discount rate
Member bank
Federal Funds rate
Asset
Liability
Demand Deposit
Bank Reserves
Reserve Requirement
Required Reserves
Excess Reserves

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. Describe the main function of financial markets. Explain how direct finance and indirect finance differ.

5. How do financial intermediaries, through their ability to pool resources promote more efficient use of financial resources? Be sure to cover risk pooling, the pooling of small investors, and pooling over time in your answer.

6. How do financial intermediaries reduce default risk, transactions costs, and matching costs?

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

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

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

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

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

12. 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.

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

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

15. Show the t-accounts and the balance sheet for the following series of transactions. 

(i) Open a bank with 10 million dollars, put 3 million into buildings and equipment.

(ii) Put 2 million of the cash into T-bills.

(iii) Deposit 1.5 million into regional Fed bank.

(iv) Collect 4 million in deposits from other banks.

(v) Let the required reserve ratio be 20% and show what happens if the bank loans out all excess reserves.

16. 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. Why are the deposit multiplier and the money multiplier the same when there is no currency and when banks loan out all excess reserves?

17. 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. [Update: This question had a mistake in it - we hadn't covered excess reserves and currency as part of the multiplier yet. It's been fixed.]

Past Midterms and Finals Posted

I posted old midterms and finals from 1995-2004. The years 2001 and 2002 are missing as I was away those years.

Click on either "Midterms" or "Finals" on the sidebar to access them.

Material for Monday 1/30/06

Today:

Ritter, Silber, and Udell:  Finished chapter 17.

Mishkin:  Finished chapter 14.

Next Time:

Ritter, Silber, and Udell:  Begin chapter 18.

Mishkin:  Begin chapter 15.

Bush is Moving to Fill Two Slots at the Federal Reserve

As we just talked about this in class, I thought I'd pass along news from Greg Ip and John McKinnon at the Wall Street Journal on Bush's choice to fill the two open seats on the Federal Reserve Board of Governors [posted here]:

Bush Is Moving To Fill Two Slots At Federal Reserve, by Greg Ip and John D. McKinnon, WSJ: With leadership at the Federal Reserve about to change, the White House is moving to fill two vacancies on the central bank's seven-member board of governors. President Bush plans to soon nominate Kevin M. Warsh, a White House adviser on domestic finance and capital markets, to fill one of the two vacancies, two people familiar with the matter said. Mr. Bush aims to fill the other seat with an academic economist, and the likeliest candidate is Randall S. Kroszner, who teaches at the University of Chicago's Graduate School of Business, one of these people said...

The nominations would tilt the board's composition toward financial-industry expertise rather than macroeconomics. Mr. Warsh, a lawyer by training, was an investment banker at Morgan Stanley before joining the White House National Economic Council. He has been the White House's point person on financial-industry issues. Mr. Kroszner, who served on the Council of Economic Advisers during Mr. Bush's first term, specializes in banking, banking regulation, international-financial crises and monetary economics...

From Brad DeLong on Richard Kroszner:

I know I'm proud to have played a (alas, very small) part in the education of Randy Kroszner and Robin Hanson, both far to my right.

From Institutional Economics:

Both Clarida and Kroszner would be excellent appointments.  Appointing non-specialists with financial market backgrounds would be a mistake in my view, increasing the risk of ... regulatory capture by Wall Street...

That doesn't sound like a strong endorsement of Warsh. I know little about him. BusinessWeek Online has a bit more, but not much:

Warsh is the NEC's point man for contact with the financial-services industry. He has recently sought to raise his public profile by speaking to more industry groups and was mentioned as a candidate for chairman of the Securities & Exchange Commission before Bush tapped Rep. Christopher Cox (R-Calif.) for the job.

Material for Wednesday 1/25/06

Today:

Ritter, Silber, and Udell:  Chapter 17 through page 343.

Mishkin:  Chapter 14 through page 349.

Next Time:

Ritter, Silber, and Udell:  Finish chapter 17, begin chapter 18.

Finish chapter 14, begin chapter 15.

Review Questions

Economics 470/570
Winter 2006
Review Questions - Midterm 1
[pdf file]

Definitions

Medium of exchange/Double coincidence of wants
Unit of account/Multiplicity of prices
Store of value/Liquidity
Financial intermediary
Direct and indirect finance
Liquidity
FOMC
FAC
Discount window
Discount rate
Member bank
Federal Funds rate

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. Describe the main function of financial markets. Explain how direct finance and indirect finance differ.

5. How do financial intermediaries, through their ability to pool resources promote more efficient use of financial resources? Be sure to cover risk pooling, the pooling of small investors, and pooling over time in your answer.

6. How do financial intermediaries reduce default risk, transactions costs, and matching costs?

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

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

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

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

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

12. 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 (we will discuss this question next class).

Economics 470/570
Winter 2006
Review Questions - Midterm 2
[pdf file.]

Definitions

Monetary Base
Borrowed and Non-borrowed reserves
Operating and intermediate targets
Monetary Policy Goals
Defensive and Dynamic Open Market Operations
Primary, Secondary, and Seasonal Credit
Monetary aggregate
Velocity of money
Output gap
Potential output
Natural rate of output
Explain Poole's rules.
Liquidity preference

Essay

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

2. 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.

3. Using t-accounts, show that the Fed can increase the monetary base by (a) making discount loans to banks, (b) an open market purchase of government bonds from banks, or (c) an open market purchase of government bonds from an individual.

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

5. Show that the Fed cannot simultaneously control bank reserves and the federal funds rate and therefore cannot adopt both as operating targets.

6. 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?

7. 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.

8. 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 and disadvantages of each tool?

9. What are the tools, operating targets, intermediate targets, and goals of Federal Reserve Policy? How are they related?

10. Show that if the Fed controls either the federal funds rate or bank reserves, then the variance of the other variable increases.

11. Can the Fed control bank reserves exactly? Explain. Why is this important?

12. Explain the reasons for the Fed’s decision to adopt an interest rate target rather than a monetary aggregate target.

13. Explain Poole's rules.

14. What is the Taylor rule? How is it used? How well does it predict Fed policy?

15. What is the role of money in the classical model?

16. Represent the classical model using an AD-AS diagram and show that changes in money, government spending, and taxes do not affect real output. What is the AD curve in the classical model?

17. State Say’s law. What is the significance of this in terms of government stabilization policy? Explain why Malthus does not believe in Say’s law. How does classical interest theory answer address Malthus’ criticism of Say’s law?

18. Explain classical interest theory. Be sure to explain why the investment function slopes downward and the saving function slopes upward.

19. 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?

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

21. 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?

22. 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?

Economics 470/570
Winter 2006
Review Questions Through Week 9
[pdf file.]

Definitions

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. Show graphically using a money demand – money supply diagram and explain intuitively how the interest rate changes if (a) the nominal money supply increases, (b) the price level increases, (c) real income increases, and (d) autonomous money demand increases.

2. Derive the LM curve graphically and explain intuitively why the LM curve slopes upward.

3. Explain why the LM curve is vertical when money demand is unaffected by changes in the interest rate (as in the classical model). More generally, show graphically and explain intuitively how the slope of the LM curve changes when the responsiveness of money demand to the interest rate (|L_i|) increases.

4. What factors cause the LM curve to shift? In what direction do they shift the LM curve? Show the shifts graphically using money demand - money supply and LM curve diagrams.

5. Explain why setting income equal to expenditures is equivalent to setting saving equal to investment.

6. What does the 45 degree line diagram show? Show the equilibrium on the 45 degree line diagram and explain how the economy moves to equilibrium if output differs from its equilibrium value. How will the equilibrium level of output change if there is a change in autonomous consumption, investment, government spending, or taxes? Explain. How will income change if the interest rate falls?

7. What is the expenditure multiplier? Why is it useful?

8. Explain why investment is negatively related to the interest rate.

9. Derive the IS curve graphically and explain intuitively why the IS curve slopes downward.

10. Show graphically and explain intuitively how the slope of the IS curve changes when the responsiveness of investment to the interest rate (|I_i|) increases. When is investment more sensitive to changes in the interest rate, at full employment or in a recession? Explain.

11. What factors cause the IS curve to shift? In what direction do they shift the IS curve? Show the shifts graphically using 45 degree line and IS curve diagrams.

12. Show graphically and explain intuitively how an increase in (a) the money supply, and (b) government spending affects income and the interest rate in the IS-LM model.

13. Use the IS-LM model to examine how the relative effectiveness of monetary and fiscal policy changes as investment becomes less sensitive to the interest rate. Explain the result intuitively.

14. Use the IS-LM model to examine how the relative effectiveness of monetary and fiscal policy changes as money demand becomes less sensitive to the interest rate. Explain the result intuitively.

Economics 470/570
Winter 2006
Review Questions for Week 10
[pdf file.]

Definitions

Liquidity trap
Monetary shock
SRAS
Full employment
Wealth effect
Real shock
LRAS
Taylor rule
MP curve

Essay

1. Use the IS-LM model to show and explain how price adjustments return the economy to full employment when output differs from its full employment level.

2. Use the AD-AS model to show the SR and LR adjustment to AD shocks in the presence of frictions such as rigid wages.

3. What is a liquidity trap and how does it arise? Explain your answer intuitively and graphically. Is the economy more likely to be in a liquidity trap near full employment or in a recession? Explain.

4. Explain and show graphically using the IS-LM model how the economy can become stuck in a liquidity trap with output less than its full employment level. How can wealth effects overcome this problem?

5. Explain and show graphically using the IS-LM model that when investment is highly insensitive to changes in interest rates, the automatic adjustment mechanism that returns the economy to full employment can break down.

6. In the Keynesian liquidity trap version of the IS-LM model, show that, when the economy is in the liquidity trap, (a) monetary policy is ineffective, and (b) fiscal policy is fully effective.

7. What is the Taylor rule? What are the issues involved in its implementation?

8. Explain why the MP curve slopes upward.

9. Use the IS-MP model to examine the effects of an increase in government spending on output, the real interest rate, consumption, and investment.

10. Use the IS-MP model to examine the effects of tighter monetary policy on output, the real interest rate, consumption, and investment.

11. Use the IS-MP model to examine the effects of a fall in consumer confidence on output, the real interest rate, consumption, and investment.

12. Explain why the SRAS curve shifts upward when output exceeds the natural rate and downward when output is below the natural rate.

13. Derive the AD curve from the IS-MP diagram and explain why it slopes downward.

14. Use the IS-MP and AD-AS diagrams to examine the impact and long-run effects of an increase in government spending or a decrease in taxes on output, inflation, the real interest rate, consumption, and investment.

15. Use the IS-MP and AD-AS diagrams to examine the impact and long-run effects of tighter monetary policy on output, inflation, the real interest rate, consumption, and investment.

Material for Monday 1/23/06

Today:

Ritter, Silber, and Udell:  Chapter 4, pgs. 63-64, Chapter 17 through page 339.

Mishkin:  Chapter 4, pgs. 79-82, Chapter 14 through page 339.

Next Time:

Ritter, Silber, and Udell:  Finish chapter 17, begin chapter 18.

Finish chapter 14, begin chapter 15.

Fed Watch: Ready to Invert

Tim Duy with his latest Fed Watch [Originally posted here]:

Military Currency

From Boing Boing:

Lileks examines currency Jame Lileks comments on paper currency from around the world. As Coop notes, It's "jawdroppingly weird old ephemera, pleasantly seasoned with acerbic comments."

Any note that shows Johnny Cash as a jet pilot is a dollar bill I'd be proud to spend.

Of course, that's not really the Man in Black, but it has his noble cast and sorrowful mouth. Also, his left eye appears to be scarred shut, but obviously that's not the case if he's a pilot. If there had been a military coup in the US in the 60s, this is what our money would have looked like. Link

Financial Market Deregulation Under Greenspan: Did It Go Too Far?

[Originally here.]

Steven Pearlstein of the Washington Post talks about an area of Greenspan's tenure that hasn't received as much press at it might, his penchant for financial deregulation:

The Laissez-Fairest of Them All, by Steven Pearlstein, Washington Post: ...Perhaps Greenspan's most important contribution has been as the policymaker who... engineered the wholesale deregulation of the U.S. banking and financial system. In this respect, his most enduring legacy is an American economy that is not only more prone to assets bubbles, corporate scandal and financial crises, but robust enough to absorb such shocks while continuing to deliver long-term economic growth.

A determination to substitute the wisdom of markets for the heavy hand of government runs through the Greenspan story. ... There was, for example, his work on behalf of Lincoln Savings and Loan seeking permission for thrifts to branch out from boring old home loans to invest directly in commercial real estate ventures. Greenspan told Congress such powers were "essential for the financial stability and survival of the savings and loan industry." Congress agreed, but this first bit of financial deregulation spawned a crisis that nearly wiped out the industry, cost taxpayers more than $100 billion and landed Lincoln's top executive in prison.

Once installed at the Fed, Greenspan immediately began pushing Congress to repeal the Depression-era law that prevented banks from competing with investment banks in underwriting stocks and bonds. When Congress dallied, he used the Fed's supervisory authority to allow banks to circumvent the law and usher in the era of the megabank. ...

When crisis struck, Greenspan was quick on the scene with liquidity to prevent it from spreading. But he almost never saw in such episodes a reason for new regulation. Even after derivatives trading bankrupt Orange County, Calif., and the venerable Barings investment house, Greenspan fought efforts to regulate these newfangled financial instruments. And while the near collapse of Long-Term Capital required the Fed's jawboning to prevent a global financial meltdown, Greenspan opposed efforts by the Securities and Exchange Commission to initiate even modest regulation of the $1 trillion hedge fund industry.

After the Enron scandal, accounting regulators set out to draft rules to prevent companies and their lenders from using "special purpose entities" to hide indebtedness from investors. Objections from the Fed stalled adoption of the new rules, and eventually watered them down. And just yesterday came Greenspan's latest salvo in his campaign to dismantle Fannie Mae and Freddie Mac. In a letter to Sen. John E. Sununu (R-N.H.), he reprises his view that there's nothing the government-sponsored mortgage lenders do that private banks couldn't do at less cost to taxpayers, with less threat to the financial system.

As you can probably tell, I didn't much like most of these decisions. There was, and is, plenty of evidence that skillful regulation and intervention can help deter corporate fraud, protect investors from Wall Street sharpies and reduce the frequency and severity of assets bubbles and financial crises.

At the same time, Greenspan is probably right that deregulation sparked a flurry of financial innovation that has made capital cheaper and more readily available, done a better job of pricing and spreading risk and shielded the economy from the impact of financial crises. ... Greenspan summed up the trade-offs behind his deregulatory philosophy in a series of unusually lucid speeches in London in 2002, on the eve of being knighted by Queen Elizabeth. "The extent of government intervention in markets to control risk-taking," he said, "is a trade-off between economic growth and its associated potential instability, and a more civil but less stressful way of life with a lower standard of living."...

I have the same reaction. Compared to twenty years ago, there has been remarkable transition and innovation in the financial services industry driven by competition. So far, so good. But I also worry that deregulation has gone too far and made us more vulnerable to financial meltdown in the face of large and unexpected shocks. Housing markets are a good example of this. The promotion of home ownership though creative financing allows many to purchase homes that could not have done so not that long ago. But have people taken on excessive risk and thereby increased our vulnerability to a crash?

The Decline in Workplace Provided Health Coverage

[This is about health care coverage, so it's not directly related to monetary policy, but thought it might be of interest ... originally posted here.]

This is from Table 132 of this report from the CDC web site. It's a graph of the percentage of people with workplace provided private health coverage from 1984-2003. There's quite a bit of detail in the table including breakdowns of coverage by age, sex, race, and income level. For example, here's coverage by age:

The numerical overall changes by age are:

Age

	1984	2003	Change
Under 18 years	66.5	58.6	-7.9
18-44 years	69.6	62.2	-7.4
45-64 years	71.8	70.0	-1.8

Thus, the largest decline is for those under 45.

Here are the numerical endpoint data by sex along with the overall changes. Given the standard errors in the table (not shown here), there is little difference between males and females:

Sex

	1984	2003	Change
Male	69.8	63.3	-6.5
Female	68.4	63.3	-5.1

There are, however, big differences by income level, and the changes are larger for those under 18. As the following table shows, the decline in workplace provided health care coverage has been largest among those earning between 100% and 200% of the poverty level, a change of over 20%, while the change for those outside this range is less than 10%:

Age and Percent of Poverty Level

All ages	1984	2003	Change
Below 100 %	24.1	19.9	-4.2
100-149 %	52.4	31.8	-20.6
150-199 %	69.5	46.8	-22.7
200 % or more	85.0	78.6	-6.4
Under 18 years
Below 100 %	23.0	14.0	-9.0
100-149 %	58.3	30.1	-28.2
150-199 %	75.8	47.0	-28.8
200 % or more	86.9	79.9	-7.0

These data show that middle income families have been affected most by the decline in employer provided private health care coverage.

Update: A colleague writes to tell me:

The explanation for the decline in coverage (at least through the late 90s) is also quite interesting.  David Cutler has a paper (NBER WP #9036), arguing that the reason for the decline was not a decrease in employers offering HI, but a decrease in employees choosing to purchase insurance from their employers, primarily due to rising premiums.

New Support for Friedman's Plucking Model

[Something I thought might interest one or two of you ... originally posted here.]

Milton Friedman's "plucking model" is an interesting alternative to the natural rate of output view of the world. The typical view of business cycles is one where the economy varies around a trend value (the trend can vary over time also). Milton Friedman has a different story. In Friedman's model, output moves along a ceiling value, the full employment value, and is occasionally plucked downward through a negative demand shock. Quoting from the article below:

In 1964, Milton Friedman first suggested his “plucking model” (reprinted in 1969; revisited in 1993) as an asymmetric alternative to the self-generating, symmetric cyclical process often used to explain contractions and subsequent revivals. Friedman describes the plucking model of output as a string attached to a tilted, irregular board. When the string follows along the board it is at the ceiling of maximum feasible output, but the string is occasionally plucked down by a cyclical contraction.

Friedman found evidence for the Plucking Model of aggregate fluctuations in a 1993 paper in Economic Inquiry. One reason I've always liked this paper is that Friedman first wrote it in 1964. He then waited for almost twenty years for new data to arrive and retested his model using only the new data. In macroeconomics, we often encounter a problem in testing theoretical models. We know what the data look like and what facts need to be explained by our models. Is it sensible to build a model to fit the data and then use that data to test it to see if it fits? Of course the model will fit the data, it was built to do so. Friedman avoided that problem since he had no way of knowing if the next twenty years of data would fit the model or not. It did. I was at an SF Fed Conference when he gave the 1993 paper and it was a fun and convincing presentation. Here's a recent paper on this topic that supports the plucking framework (thanks Paul):

Asymmetry in the Business Cycle: New Support for Friedman's Plucking Model, Tara M. Sinclair, George Washington University, December 16, 2005, SSRN: Abstract This paper presents an asymmetric correlated unobserved components model of US GDP. The asymmetry is captured using a version of Friedman's plucking model that suggests that output may be occasionally "plucked" away from a ceiling of maximum feasible output by temporary asymmetric shocks. The estimates suggest that US GDP can be usefully decomposed into a permanent component, a symmetric transitory component, and an additional occasional asymmetric transitory shock. The innovations to the permanent component and the symmetric transitory component are found to be significantly negatively correlated, but the occasional asymmetric transitory shock appears to be uncorrelated with the permanent and symmetric transitory innovations. These results are robust to including a structural break to capture the productivity slowdown of 1973 and to changes in the time frame under analysis. The results suggest that both permanent movements and occasional exogenous asymmetric transitory shocks are important for explaining post-war recessions in the US.

Let me try, within my limited artistic ability, to illustrate further. If you haven't seen a plucking model, here's a graph to illustrate (see Piger and Morley and Kim and Nelson for evidence supporting the plucking model and figures illustrating the plucking and natural rate characterizations of the data). The "plucks" are the deviations of the red line from blue line representing the ceiling/trend:

Notice that the size of the downturn from the ceiling from  a→b (due to the "pluck") is predictive of the size of the upturn from b→c that follows taking account of the slope of the trend. I didn't show it, but in this model the size of the boom, the movement from b→c, does not predict the size of the subsequent contraction. This is the evidence that Friedman originally used to support the plucking model. In a natural rate model, there is no reason to expect such a correlation. Here's an example natural rate model:

Here, the size of the downturn a→b does not predict the size of the subsequent boom b→c. Friedman found the size of a→b predicts b→c supporting the plucking model over the natural rate model.

Fed Links

I posted this on my blog tonight:

There were two speeches today by Fed officials. First, there was a speech by Fed Governor Susan Bies:

Productivity and Economic Outlook

Bottom line: Likes current situation, but worried about capacity and resource constraints driving up input prices and causing in inflationary pressure.

There was also a speech by Richmond Fed President Jeffrey M. Lacker:

The Economic Outlook for 2006

Bottom line: Likes current situation, but not sure that the pass-through risk from high energy prices to core inflation is over. One more rate hike, then assess incoming data to see where to go next.

Here's the Bloomberg write-up of the speeches:

Fed Officials See Inflation Risks From Oil, Rising Factory Use

And also from Bloomberg, Gene Sperling assesses Greenspan's record. He has quarrels with particular episodes such as the 2001 tax cut, but overall sees Greenspan's record in a positive light:

Time to Judge the Whole Record of Alan Greenspan

Material for Wednesday 1/18/06

Today:

Ritter, Silber, and Udell:  Chapter 2

Mishkin:  Chapter 3

Next Time:

Ritter, Silber, and Udell:  Chapter 4, pgs. 63-64, Chapter 17

Mishkin:  Chapter 4, pgs. 79-82, Chapter 14

Books on Reserve

Both books are now on reserve.

A Brief History of the U.S. Payments System

Anthony M. Santomero, President of the Philadelphia Fed, discusses the evolution of our payments system.  The history starts at a time in the U.S. when each bank issued its own checks and currency and banks are chartered and regulated by individual states rather than by the federal government.  He talks about some of the problems that arrangement causes for transactions, particularly over long distances, and how the federal government attempts to solve this by introducing a national currency and check clearing system.

The Evolution of Central Banking in the United States

A very nice history of central banking in the United States from Federal Reserve Vice Chairman Roger W. Ferguson, Jr. with comparisons to the introduction of the Euro and the European Central Bank:

The Evolution of Central Banking in the United States, Vice Chairman Roger W. Ferguson, Jr., The European Central Bank, Frankfurt, Germany, April 27, 2005

…I would like to discuss the evolution of central banking in the United States, with particular reference to currency, relations between the regions and the center, mandates, and communication. Along the way, I will compare our experience with that of the ECB…

Material for Wednesday 1/11/06

Today:

We covered this from Mishkin's text.

Next Time:

Ritter, Silber, and Udell:  Chapter 2

Mishkin:  Chapter 3

Lecture 17

Covers:
Chapter 28, 671-677

Alternate: Google Video - click to launch

Return to Video Lectures Index - Summer 2006
Return to Video Lectures Index - Fall 2006
Return to Video Lectures Index - Winter 2007 

Lecture 17 (Windows Media File)

Download Lecture 17

Lecture 16

Covers:
Chapter 28, 660-671

Alternate: Google Video - click to launch

Return to Video Lectures Index - Summer 2006
Return to Video Lectures Index - Fall 2006
Return to Video Lectures Index - Winter 2007 

Lecture 16 (Windows Media File)

Download Lecture 16

Lecture 15

Covers:
Chapter 27, pgs. 646-655; Chapter 28, 658-660

Alternate: Google Video - click to launch

Return to Video Lectures Index - Summer 2006
Return to Video Lectures Index - Fall 2006
Return to Video Lectures Index - Winter 2007 

Lecture 15 (Windows Media File)

Download Lecture 15

Lecture 14

Covers:
Chapter 25, pgs. 594-600; Chapter 27, pgs 632-646

Alternate: Google Video - click to launch

Return to Video Lectures Index - Summer 2006
Return to Video Lectures Index - Fall 2006
Return to Video Lectures Index - Winter 2007 

Lecture 14 (Windows Media File)

Download Lecture 14

 

Lecture 13

Covers:
Chapter 25, pgs. 582-594

Alternate: Google video - click to launch

Return to Video Lectures Index - Summer 2006
Return to Video Lectures Index - Fall 2006
Return to Video Lectures Index - Winter 2007 

Lecture 13 (Windows Media File)

Download Lecture 13

Lecture 12

Covers:
Chapter 24, pgs. 571-580

Alternate: Google video - click to launch

Return to Video Lectures Index - Summer 2006
Return to Video Lectures Index - Fall 2006
Return to Video Lectures Index - Winter 2007 

Lecture 12 (Windows Media File)

Download Lecture 12

 

Lecture 11

Covers:
Chapter 24, pgs. 568-571

Alternate: Google video - click to launch

Return to Video Lectures Index - Summer 2006
Return to Video Lectures Index - Fall 2006
Return to Video Lectures Index - Winter 2007 

Lecture 11 (Windows Media File)

Download Lecture 11

Lecture 10

Covers:
Chapter 23, pgs. 555-558; Chapter 24, pgs. 561-568

Alternate: Google video  - click to launch

Return to Video Lectures Index - Summer 2006
Return to Video Lectures Index - Fall 2006
Return to Video Lectures Index - Winter 2007

Lecture 10 (Windows Media File)

Download Lecture 10

Lecture 9

Covers:
Chapter 23,  pgs. 536-555

Alternate: Google video - click to launch

Return to Video Lectures Index - Summer 2006
Return to Video Lectures Index - Fall 2006
Return to Video Lectures Index - Winter 2007 

Lecture 9 (Windows Media File)

Download Lecture 9

Lecture 8

Covers:
Chapter 22,  pgs. 524-533

Alternate: Google video - click to launch

Return to Video Lectures Index - Summer 2006
Return to Video Lectures Index - Fall 2006
Return to Video Lectures Index - Winter 2007 

Lecture 8 (Windows Media File)

Download Lecture 8

Lecture 7

Covers:
Chapter 22,  pgs. 517-524

Alternate: Google video - click to launch

Return to Video Lectures Index - Summer 2006
Return to Video Lectures Index - Fall 2006
Return to Video Lectures Index - Winter 2007 

Lecture 7 (Windows Media File)

Download Lecture 7

Lecture 6

Covers:
Chapter 16,  pgs. 374-391
Chapter 17, pgs. 393-408

Alternate: Google video - click to launch

Return to Video Lectures Index - Summer 2006
Return to Video Lectures Index - Fall 2006
Return to Video Lectures Index - Winter 2007 

Lecture 6 (Windows Media File)

Download Lecture 6

Lecture 5

Covers:
Chapter 15,  pgs. 364-371

Alternate: Google video - click to launch

Return to Video Lectures Index - Summer 2006
Return to Video Lectures Index - Fall 2006
Return to Video Lectures Index - Winter 2007 

Lecture 5 (Windows Media File)

Download Lecture 5

Lecture 4

Covers:
Chapter 14,  pgs. 346-354
Chapter 15, pgs. 357-364

Alternate: Google Video - click to launch

Return to Video Lectures Index - Summer 2006
Return to Video Lectures Index - Fall 2006
Return to Video Lectures Index - Winter 2007 

Lecture 4 (Windows Media File)

Download Lecture 4

Lecture 3

Covers:
Chapter 14,  pgs. 335-346

Alternate: Google Video - click to launch

Return to Video Lectures Index - Summer 2006
Return to Video Lectures Index - Fall 2006
Return to Video Lectures Index - Winter 2007 

Lecture 3 (Windows Media File)

Download Lecture 3

Lecture 2

Covers:
Chapter 3, pgs. 48-55
Chapter 4, pgs. 79-82

Alternate: Google Video - click to launch

Return to Video Lectures Index - Summer 2006
Return to Video Lectures Index - Fall 2006
Return to Video Lectures Index - Winter 2007 

Lecture 2 (Windows Media File)

Download Lecture 2

Lecture 1

Covers:
Chapter 1, pgs. 8-13
Chapter 3, pgs. 23-48

Alternate: Google Video - click to launch

Return to Video Lectures Index - Summer 2006
Return to Video Lectures Index - Fall 2006
Return to Video Lectures Index - Winter 2007

Lecture 1 (Windows Media File)

Download Lecture 1

Reading from Mishkin's Text

Functions of Financial Intermediaries from Mishkin pages 29-32:

 

Material for Monday 1/9/06

Today:

Ritter, Silber, and Udell:  ch. 1 (this is mostly about jobs available in economics and money and banking) and ch. 3, pgs. 23-25 (not on syllabus, but relates to what we did at the end of class).

Mishkin:  pgs. 3-12 and 23-25

Next Time:

Ritter, Silber, and Udell:  Chapter 2

Mishkin:  Chapter 3

Syllabus for Winter 2006

Course: Economics 470/570 - Monetary Theory and Policy
Professor: Mark Thoma
Office/Hours: PLC 471 on M/W 12:30-1:30 p.m.
Phone/Email: (541) 346-4673, [email protected]
Web Page: http://economistsview.typepad.com/economics470/

Text: Principles of Money, Banking, and Financial Markets, 11th edition, by Ritter, Silber, and Udell, Pearson Addison-Wesley.
Alternate 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:

Matt Miller    T/Th  3:30-4:30  and  F  1:00-2:00    PLC 504    [email protected]

Tests and Grading: There will be two midterm exams and a final. The midterms will be given Monday, February 6th and Monday, February 27th. The final will be given on Tuesday, March 21st at 10:15 a.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 upon the problem sets.

Tentative Course Outline:

Introduction	Ritter, Silber, Udell	Mishkin
Introduction	ch. 1
Money in the Macroeconomy	ch. 2, 4, pgs. 63-64	ch. 3
Banks and Other Intermediaries
Financial Intermediation	class notes
The Conduct of Monetary Policy
The Federal Reserve System	ch. 17	ch. 14
Bank Reserves and the Money Supply	ch. 18	ch. 15
Instruments of Monetary Policy	ch. 19	ch. 16
Monetary Policy Strategy	ch. 21	ch. 17

Monetary Theory
The Classical Foundations	ch. 22	ch. 22
The Keynesian Framework	ch. 23	ch. 23
The IS-LM Model	ch. 24
Short-Run Stabilization Policy	ch. 25	ch. 24
The AS-AD Model and Stabilization	ch. 26	ch. 25
Rational Expectations	ch. 27	ch. 27, 28

Fed Watch: A Little Something for Everyone

[This originally appeared here. Brad DeLong is using it as part of his class at Berkeley on journalism and economics.  See here.]

Tim Duy looks through the eyes of monetary policymakers at today's employment report and its impact on the course of monetary policy:

What better way to return from a long winter break than to tackle a muddled labor report!  I suspect that we will find many stories told about this report, and I will try to summarize all of them (Kash at Angry Bear was out of the gates early with the pessimist’s take).  But what is most important – from a FedWatch perspective – is the view at Constitution Ave. I tend to think that despite a few setbacks in the details, policymakers will walk away with a relatively upbeat perspective on the labor markets. And that means it may be premature to think the Fed will shortly be done for good.

But first, a quick look back at the Fed minutes. Wall Street’s stamp of approval implies a wide expectation of “one and done” for this tightening cycle. That’s not quite my interpretation, although I can’t blame traders for looking for good news after a dreary December.  Instead, I left the minutes with the sense that another rate hike at the end of the month is in the bag, but beyond that, future changes in policy are not automatic but instead data dependent.  That is decidedly not the same thing as “done.”  “Done” means you are betting against the economy – and I doubt the Fed is ready to make that call just yet.

As far as the labor report goes, the headline payroll gain of 108,000 was clearly a disappointment.  But optimists will point to the revision that pushed the October gain to 305,000 jobs, which yields a respectable two-month average of just over 200,000. Optimists will point to the decline in the unemployment rate to 4.9%; pessimists will focus on the decline in the labor force participation rate.  Pessimists will focus on the slight fall in aggregate hours worked; optimists will point to the 5 cent wage gain.

Some other details popped out at me.  The 18,000 gain in manufacturing employment should be happy news to many, although my initial scan of the blogs does not show a focus on this number.  In contrast, the decrease in construction employment could reflect cooling housing markets.  While many expect those jobs will eventually show up in Gulf Coast rebuilding efforts, only in macroeconomic textbooks does a worker move from San Diego to New Orleans instantaneously and at zero cost. 

So, what will policymakers make of all of this? First of all, it is always important to remember that one month of a single data report is not likely to fundamentally alter the perceptions on Constitution Ave. We will have two more of these reports – not to mention dozens of other data points – by the time the March meeting rolls around.  If, then, the overall trends are what is important, can we find some consistency in the data of the optimists and pessimists? For this I turn to Table A12 of the employment report, a personal favorite of mine. Table A12 reports different measures of labor underutilization. The most optimistic measure is:

Percent of Civilian Labor Force Unemployed 15 Weeks & Over

The most pessimistic measure is:

Total Unemployed, Plus All Marginally Attached Workers Plus Total Employed Part Time For Economic Reasons, As A Percent Of All Civilian Labor Force Plus All Marginally Attached Workers

The headline unemployment rate at 4.9% basically splits the difference.

What do both of these pictures have in common? Both measures place labor market utilization near the rates seen prior to the great boom of the late 1990’s. Do policymakers believe that the late 1990’s can be repeated? Or was that period an aberration, and attempts to recreate that environment will only lead to higher inflation expectations?

I tend to believe that policymakers favor the latter interpretation. That implies if overall economic data points to stabilization in these measures, the Fed will be content to sit back after this next hike and wait to see how their medicine works. But if these measures continue to decline in concert with strong coincident and leading data, the Fed will feel obligated to move rates higher in March and possibly beyond. I believe this interpretation will not be well received by the labor market pessimists.

What about the employment to population ratio? PGL an Angry Bear points to a decline over the past five years as a sign of a weak labor market.  This short run view of the data raises the same question: Was the push higher in the late 1990’s a reflection of a once-in-a-generation stock market boom? Do we really want the Fed to recreate those conditions? Do we really expect them to? And a longer run view raises another batch of questions:

Employment to Population Ratio

Here you are stuck with disentangling the cyclical behavior with the secular trends.  If we attribute rising employment participation to increased female participation in the labor force, and if that trend has pretty much been maxed out while male labor force participation continues to slide, and we believe the boomers are starting to retire, then I am not sure we can expect much higher employment to population numbers short, again, of 1990’s style boom.

Similar thoughts can be said of Mark Thoma’s questions regarding stagnant numbers among marginally attached workers in the post below this one.  You have to raise the question of what type of environment is necessary to draw these workers back into the labor force, and will the Fed attempt to do so?

Truth be told, I honestly don’t know the “correct” level for any of these measures of the labor market. Nor would I, or anyone at the Federal Reserve, say the job market is as strong as in the late 1990s.  My point is that from a policy perspective, the last cycle may not be the relevant reference point.  Pointing to the Clinton Era might be like pointing to the 1980’s in Japan – remember when Tokyo had all the answers?  It was fun while it lasted, but it isn’t likely to happen again. If instead, we assume that the Fed sees labor markets as relatively healthy, and that they see this view as supported by rising wages (accelerating to 3.1% over the past year), then the next step for the Fed is to determine the impact on the inflation outlook. And that again raises enough questions to keep a central banker awake at night:

• To what extent do rising wages reflect productivity gains, tight labor markets, and pass through from this summer’s surge in headline inflation?
• How much of the wage gain will firms be able to pass through to core prices?
• Has past monetary policy already put enough tightening into the system to head off any pass through to core prices?
• What about the pressure exerted through rising commodity prices?  Note that oil prices are creeping upward toward $70 again.  Also watch metals (copper and gold).
• Is the housing market slowdown turning into a full blown bust?

With so many variables in play, it is not surprising that the Fed wants to change the game plan.  To date, policy has been driven by the desire to normalize interest rates. But now that we are at a more neutral level, the next policy steps aren’t so clear. This is why policy is now data dependent, and why anything beyond Greenspan’s final move is fuzzy.  [All Fed Watch posts.]

[Update from Mark Thoma: Dallas Fed president Richard Fisher and Boston Fed president Cathy Minehan gave speeches today (1/6/06) at the ASSA meetings in Boston. From Bloomberg:

"We may be entering a period in which policy changes are even more dependent than they have been on current readings of the economy, with all the uncertainty such readings can bring,'' Minehan said. "As the Committee's minutes have suggested and its recent policy statement confirms, its communication is evolving.''

And also:

Fisher didn't speak in any detail about the near-term course of interest-rate policy. Minehan said policy makers will have to watch economic data to determine their next steps now that the Fed has removed most of the "accommodation'' from the economy. Investors should understand that Fed statements aren't going to give them a clear road map of future rate moves in that environment, Minehan said.]

And Never is Heard a Discouraging Word?

[This originally appeared here. Brad DeLong is using it as part of his class at Berkeley on journalism and economics.  See here - the link is towards the bottom of the reading list.]

The Labor Department reported today that employment increased by 108,000 over November, a number that is lower than expected, and the unemployment rate held steady at 4.9%. This is a brief follow-up to PGL's post at Angry Bear on the unemployment, labor force participation, and discouraged worker numbers (Kash has more). A sign of an improving labor market is a fall in discouraged workers. However, according to today's report from the BLS:

Persons Not in the Labor Force (Household Survey Data)

The number of persons marginally attached to the labor force was 1.6 million in December, about the same as a year earlier. (Data are not seasonally adjusted.) These individuals wanted and were available to work and had looked for a job sometime in the prior 12 months. They were not counted as unemployed, however, because they did not actively search for work in the 4 weeks preceding the survey. Among the marginally attached, there were 451,000 discouraged workers in December, essentially the same as a year earlier. Discouraged workers were not currently looking for work specifically because they believed no jobs were available for them. The other 1.1 million marginally attached persons had not searched for work for reasons such as school attendance or family responsibilities. (See table A-13.)

It's puzzling why the number of marginally attached discouraged workers isn't falling if the labor market is strengthening. The news is a bit better relative to a year ago for part-time workers wanting to work full-time:

Total Employment and the Labor Force (Household Survey Data)

Total employment, at 142.8 million in December, was little changed over the month but was 2.6 million higher than a year earlier. The employment- population ratio held at 62.8 percent in December, 0.4 percentage point higher than a year earlier. The labor force participation rate, at 66.0 percent, was unchanged over the year. (See table A-1.)

The number of persons who work part time for economic reasons, at 4.1 million, was about unchanged in December but was down by 327,000 over the year. This category includes persons who indicated that they would like to work full time but were working part time because their hours had been cut back or because they were unable to find full-time jobs. (See table A-5.)

See PGL's post for a look at these figures over a longer time period. With both employment and real income behaving sluggishly by historical standards, the labor market is not as robust as would be expected in a recovery.

Midterm 2

Economics 470/570
Winter 2005 (worth 1 point)
Midterm #2

Part I - Definitions. Define each of the following (3 points each, 18 points total).

1. Autonomous expenditures

2. Crowding out

3. Inflationary and recessionary gaps

4. Policy ineffectiveness proposition

5. Menu costs

6. Wealth effect

Part II - Short Answer. Answer THREE of the following questions (9 points each, 27 points total).

1. What is the expenditure multiplier? Why is it useful?

2. When is money demand more sensitive to changes in the interest rate, at full employment or in a recession? Explain.

3. Use the IS-LM model to show that the model is classical in the LR, i.e. that (a) output does not change in the LR, (b) monetary shocks do not affect the real interest rate in the LR, (c) real shocks do affect the real interest rate in the LR.

4. Derive the SRAS and LRAS curves for the New Classical model.

Part III – Essays and problems. Answer THREE of the following questions (18 points each, 54 points total)

1. Use the IS-LM model to examine how the relative effectiveness of monetary and fiscal policy changes as investment becomes less sensitive to the interest rate. Explain the result intuitively.

2. (a) What is a liquidity trap and how does it arise? Explain your answer intuitively and graphically. Is the economy more likely to be in a liquidity trap near full employment or in a recession? Explain. (b) Explain and show graphically using the IS-LM model how the economy can become stuck in a liquidity trap with output less than its full employment level. How can wealth effects overcome this problem?

3. 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? Are there substantial differences for monetary and fiscal policy?

4. 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?

[Midterm 2 Solution]

Midterm 1

Economics 470/570
Winter 2005 (worth 1 point)
Midterm #1

Part I - Definitions. Define each of the following (3 points each, 18 points total).

1. Direct and indirect finance

2. Federal Funds rate

3. Bank Reserves

4. Monetary Base

5. Defensive and Dynamic Open Market Operations

6. Output gap

Part II - Short Answer. Answer THREE of the following questions (9 points each, 27 points total).

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

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

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

4. What is the Taylor rule? How is it used? How well does it predict Fed policy?

Part III – Essays and problems. Answer THREE of the following questions (18 points each, 54 points total)

1. 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.

2. Show the t-accounts and the balance sheet for the following series of transactions. (i) Open a bank with 5 million dollars, put 2 million into buildings and equipment. (ii) Put 1 million of the cash into T-bills. (iii) Deposit .5 million into regional Fed bank. (iv) Collect 1.5 million in deposits from other banks. (v) Let the required reserve ratio be 10% and show what happens if the bank loans out all excess reserves.

3. 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 increase.

4. (a) State Say’s law. What is the significance of this in terms of government stabilization policy? Explain why Malthus does not believe in Say’s law. How does classical interest theory answer address Malthus’ criticism of Say’s law? (b) Explain why the investment function slopes downward and the saving function slopes upward.

[Midterm 1 Solution]

Final Exam

Economics 470/570
Winter 2005
Final Exam

Part I - Definitions. Define each of the following (2 points each, 12 points total).

1. Liquidity

2. Discount window and Discount rate

3. Velocity of money

4. Policy effectiveness

5. Monetary shock and Real shock

6. Natural rate hypothesis

Part II - Short Answer. Answer FOUR of the following questions (7 points each, 28 points total).

1. Show that the Fed cannot simultaneously control bank reserves and the federal funds rate and therefore cannot adopt both as operating targets.

2. What is the difference between real and nominal interest rates? How do the ex-ante and ex-post real interest rates differ?

3. Derive the IS curve graphically and explain intuitively why the IS curve slopes downward.

4. Use the fixed wage AD-AS model to show the SR and LR adjustment to AD shocks.

5. How does the New Keynesian model differ from the traditional Keynesian and New Classical models?

Part III – Essays and problems. Answer FOUR of the following questions (15 points each, 60 points total)

1. 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?

2. 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 and disadvantages of each tool

3. 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?

4. Use the IS-LM model to examine how the relative effectiveness of monetary and fiscal policy changes as money demand becomes less sensitive to the interest rate. Explain the result intuitively.

5. 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.