Economics 470/570 - Monetary Theory and Policy

Office Hours

In case you didn't get the email I sent to the class, office hours today (Monday 3/20) will be from 1:30-2:30.

UPDATE: On my blog, my sitetracker shows several people in the last hour using Google to search for "monetary shock" and  visiting a post on the dynamic adjustment to monetary shocks.

Given that, I thought I'd define this term:

A real shock is simply a shock to a real variable, real output, real wages, productivity, that sort of thing, with productivity a common choice.

A monetary shock is a shock to the money supply, to nominal prices, to any nominal variable, e.g. the nominal wage.

Material for Monday 3/13/06

Today:

Ritter, Silber, and Udell:  Chapters 25

Mishkin:  Chapter 24

Next Time:

This is a good reference (campus access): Keynesian Macroeconomics without the LM Curve

Federal Funds Rate Probabilities for Future Meetings

These are from David Altig at macroblog and are based on the programs and data given at the end (click on the figures for larger versions). David is part of the research division at the Cleveland Fed. They are the probabilities, based upon futures markets, of rate hikes at the next few FOMC meetings:

macroblog: Funds Rate Probabilities: Locking In 5, By David Altig The big move of the week in the Carlson-Craig-Melick estimates of market expectations for the federal funds rate path was not in the March meeting, where there wasn't much room to move in the first place...

... but in the May meeting, where another 25 basis points is now being priced in the options market as a dead cinch:

Sentiments in the direction of yet another move at the June meeting ran hot and cold over the week:

I'll declare that race wide open.

The usual data...
Download Imp_pdf_slides_for_blog_031006.ppt
Download implied_pdf_march_031006.xls
Download implied_pdf_may_031006.xls
Download implied_pdf_june_031006.xls

... and a new item the menu, the pictures in flash format:
Download Imp_pdf_slides_for_blog_031006.swf

Review Questions Through Week 9

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.

Paul Krugman's Introduction to Keynes' General Theory

I thought some of you might want to read this. It's Paul Krugman's introduction to Keynes' General Theory of Employment, Interest, and Money:

Introduction by Paul Krugman to The General Theory of Employment, Interest, and Money, by John Maynard Keynes

SYNOPSIS:

Introduction

In the spring of 2005 a panel of “conservative scholars and policy leaders” was asked to identify the most dangerous books of the 19th and 20th centuries. You can get a sense of the panel’s leanings by the fact that both Charles Darwin and Betty Friedan ranked high on the list. But The General Theory of Employment, Interest, and Money did very well, too. In fact, John Maynard Keynes beat out V.I. Lenin and Frantz Fanon. Keynes, who declared in the book’s oft-quoted conclusion that “soon or late, it is ideas, not vested interests, which are dangerous for good or evil,” [384] would probably have been pleased.

Over the past 70 years The General Theory has shaped the views even of those who haven’t heard of it, or who believe they disagree with it. A businessman who warns that falling confidence poses risks for the economy is a Keynesian, whether he knows it or not. A politician who promises that his tax cuts will create jobs by putting spending money in peoples’ pockets is a Keynesian, even if he claims to abhor the doctrine. Even self-proclaimed supply-side economists, who claim to have refuted Keynes, fall back on unmistakably Keynesian stories to explain why the economy turned down in a given year.

In this introduction I’ll address five issues concerning The General Theory. First is the book’s message – something that ought to be clear from the book itself, but which has often been obscured by those who project their fears or hopes onto Keynes. Second is the question of how Keynes did it: why did he succeed, where others had failed, in convincing the world to accept economic heresy? Third is the question of how much of The General Theory remains in today’s macroeconomics: are we all Keynesians now, or have we either superseded Keynes’s legacy, or, some say, betrayed it? Fourth is the question of what Keynes missed, and why. Finally, I’ll talk about how Keynes changed economics, and the world.

Material for Wednesday 3/8/06

Today:

Ritter, Silber, and Udell:  Finish chapters 23, 24

Mishkin:  Finiah chapter 23

Next Time:

Ritter, Silber, and Udell:  Chapters 25

Mishkin:  Chapter 24

Inflation Fighting Credentials

I hear a lot about Bernanke needing to establish his inflation fighting credentials, something I don't think is necessary, but others apparently do. So I was curious to see how Greenspan fared in this regard in comparison.

Midterm 2 Solution

Midterm and Solution.

Material for Monday 3/6/06

Today:

Ritter, Silber, and Udell:  Continue chapters 23, 24

Mishkin:  Continue chapter 23

Next Time:

Ritter, Silber, and Udell:  Finish chapters 23, 24

Mishkin:  Finish chapter 23

Grade Distribution through Midterm 2

Here is the grade distribution through midterm 2. It is based upon the average of the two scores:

Undergrad			Grad
95	A		95	A
95	A		93	A
95	A		89	A-
93	A		86	B
93	A		80	B-
92	A-
91	A-
90	A-
90	A-
89	A-
89	A-
89	A-
88	B+
88	B+
87	B+
86	B+
83	B
82	B
81	B-
80	B-
79	B-
79	B-
78	C+
77	C+
76	C+
74	C
73	C
73	C
72	C
71	C
69	C-
69	C-
67	C-
67	C-
63	D
61	D
60	D
58	F
51	F

Regulatory Relief for Banking Organizations

Today, Federal Reserve Governor Donald Kohn testified before the Committee on Banking, Housing, and Urban Affairs in the Senate on regulatory relief proposals for banking organizations the Fed would like to see implemented. Here are four of the thirty six proposals: 

Appendix: Regulatory Relief, Proposals Supported by the Board of Governors of the Federal Reserve System, Testimony of Donald Kohn: The Board believes the first 20 items listed below would provide meaningful regulatory relief to banking organizations within the jurisdiction of the Federal Reserve. The remaining 16 items would improve the supervision of banking organizations, facilitate the resolution of failed banks, streamline procedural or other requirements under the federal banking laws, or eliminate outdated provisions of law.

1. Authorize the Federal Reserve to pay interest on balances held at Reserve Banks ...gives the Federal Reserve explicit authority to pay interest on balances held by depository institutions at the Federal Reserve Banks....
   
2. Authorize depository institutions to pay interest on demand deposits ...repeals the provisions in current law that prohibit depository institutions from paying interest on demand deposits. If adopted, the amendment would allow all depository institutions that have the authority to offer demand deposits to pay interest on those deposits.
   
3. Ease restrictions on interstate branching and mergers in a competitively equitable manner ...authorizes national and state banks to open de novo branches on an interstate basis. Currently, banks may establish de novo branches in a new state only if the state has affirmatively authorized de novo branching. This existing limitation places banks at a disadvantage to federal savings associations ...
   
4. Allow insured banks to engage in interstate merger transactions with savings associations and trust companies ...would allow an insured bank to directly acquire, by merger, an insured savings association or uninsured trust company in a different home state without first converting ... into an insured bank. As under current law, the insured bank would have to be the survivor of the merger.

For me, an interesting feature of this is the following:

Having the authority to pay interest on excess reserves also could help mitigate potential volatility in overnight interest rates. If the Federal Reserve was authorized to pay interest on excess reserves, and did so, the rate paid would act as a minimum for overnight interest rates, because banks generally would not lend to other banks at a lower rate than they could earn by keeping their excess funds at a Reserve Bank. Although the Board sees no need to pay interest on excess reserves in the near future, the ability to do so would be a potentially useful addition to the monetary policy toolkit of the Federal Reserve.

The discussion, discussed previously here, brings up the possibility of a "channel" or "corridor" system for setting the federal funds rate as is currently in place in Canada, Australia, and new Zealand. This system makes open market operations unnecessary and allows the Fed, as proposed elsewhere on the proposed list or regulatory changes, to remove reserve requirements. Currently, the federal funds rate is capped by the discount rate. Since the Fed will lend to banks at the discount rate, no bank would pay a higher rate in the federal funds market so the federal funds rate cannot go any higher than the discount rate. Similarly, with the ability to pay interest on deposits, no bank would lend to another bank at less than the rate the Fed will pay on deposits, so the federal funds rate cannot be lower than this. These two bounds are shown in the figure below (copied from Mishkin's text). Notice that if these bounds are fairly tight, the federal funds rate will be controlled precisely (for more on this point, see Woodford). In addition, keeping the federal funds rate on target does not require open market operations, only discount window (lombard facility) borrowing and lending.

Material for Wednesday 3/1/06

Today:

Ritter, Silber, and Udell:  Chapters 23, 24

Mishkin:  Chapter 23

Next Time:

Ritter, Silber, and Udell:  Continue chapters 23, 24

Mishkin:  Continue chapter 23