Economics 470/570 - Monetary Theory and Policy

Review Material for Midterm

Review Material for Midterm
Economics 470/570
Fall 2009

These are review questions for the midterm exam which will be on Thursday, November 5. The list is extensive - it covers all the topics we have covered in class that you are responsible for.  The test itself will be multiple choice, but a thorough understanding of these questions is a good study guide for the exam.

Definitions

Financial Intermediary
Indirect finance
Direct finance
Adverse selection
Moral hazard
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
Nominal anchor
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
Money multiplier
Quantity equation
Velocity of money
Equation of exchange

Questions

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 13

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 14

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?

19. 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.

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

21. 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.

22. 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

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

24. 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.

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

26. 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.

Chapter 19

27. 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?

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

29. 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?

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

31. 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?

[Many of these are also homework problems]

Class Materials for Lecture 9

Brief Outline of Topics Covered in Lecture 9

Chapter 19 Money Demand [cont.]

Keynes’s Liquidity Preference Theory

• Transactions Motive
• Precautionary Motive
• Speculative Motive
• Putting the Three Motives Together

Further Developments in the Keynesian Approach

• Why Transactions demand depends upon i (Baumol)
• Tobin's Uncertainty Theory

Friedman’s Modern Quantity Theory of Money

Chapter 20 The IS-LM Model [unlikely we'll get this far today]

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:

Class Material:

Additional Reading:

• Bill Would Shift Cost of Rescuing Banks to Large Companies - NYTimes.com
• Improving financial regulation and supervision - Econbrowser
• Efficient Market Theory and the Crisis - Jeremy J. Siegel - WSJ.com
• Financial crises are different! - voxeu.org
• Report: GMAC in Talks for Bailout, and Summary - Calculated Risk
• A Language of Smiles - Olivia Judson
• Novel Analysis Confirms Climate "Hockey Stick" Graph - Scientific American
• SuperFreakonomics Ignores Business Case for Sustainability - Climate Progress
• Can renewable energy save the world? - voxeu.org
• How to avoid a repeat of the Great Crash - FT.com
• America, The Land of Opportunity - Capital Gains and Games
• Selling stocks short: Ever controversial - macroblog
• Is it all the finance profs' fault - The Curious Capitalist

Application:

Stabilization policy when prices are slow to adjust.

Homework #4

Economics 470/570
Fall 2009
Homework #4
Due Tuesday, November 3

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. Explain why the money demand curve 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? Explain.

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

Class Materials for Lecture 8

Brief Outline of Topics Covered in Lecture 8

Chapter 15 Tools of Monetary Policy [cont.]

• 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

Video:

Class materials:

Additional Reading:

• The Economic Bomb That Didn’t Drop - The Caucus
• Why banks stay big - The New Yorker
• Econometric methodology for human mating - Aid Watch
• Obama Adviser Expects Jobless Rate to Top 10% - NYTimes.com
• Financial Regulation and Supervision after the Crisis - FRB: Bernanke
• Fed Weighs Shift to Market Signals - WSJ.com
• Content of economic blogs - Antonio Fatas
• Oil prices in currencies other than the USD - Worthwhile Canadian Initiative
• Private Saving, Household Saving, and Rebalancing - Econbrowser
• International reserves and easy money may have caused the crisis - G. Calvo
• Recent Developments in Mortgage Finance - FRBSF Economic Letter
• Volcker’s A Guy Who Knows A Thing Or Two - Market Talk

Application:

How does health care reform impact monetary policy?

---

Also, 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. ...

“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...

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

Class Materials for Lecture 7

Brief Outline of Topics Covered in Lecture 7

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

Video:

Additional Reading:

• Holding Off Disaster - The Race to Save Lehman - NYTimes.com
• Oliver Williamson, a gentleman. - Virulent Word of Mouse
• How Moody's sold its ratings -- and sold out investors - McClatchy
• The September CPI with all the trimmings - macroblog
• Greenspan Says U.S. Should Consider Breaking Up Large Banks - Bloomberg.com
• Federal Contractors Report 30,000 Stimulus Jobs - washingtonpost.com
• Understanding a systemic banking crisis - voxeu.org
• Why the US dollar may strengthen in 2010 - voxeu.org

Application:

Ben Bernanke:

Fed Chief Cites Trade Imbalances’ Role in Crisis, by Edmund Andrews, NY Times: Ben S. Bernanke, the chairman of the Federal Reserve, said on Monday that global trade imbalances played a central role in the global economic crisis and warned that the both the United States and fast-growing Asian nations needed to do more to prevent them from recurring.

“We were smug,” Mr. Bernanke said of the United States, saying the American financial regulatory system was “inadequate” at managing the immense inflows of cheap money from China and other countries that had huge trade surpluses.

Though the Fed chairman acknowledged that trade imbalances have declined sharply as a result of the crisis, mainly because trade itself plunged, he warned that American foreign indebtedness will aggravate the imbalances once again unless the United States reduces its soaring federal budget deficit.

“The United States must increase its national saving rate,” he said. “The most effective way to accomplish this goal is by establishing a sustainable fiscal trajectory, anchored by a clear commitment to substantially reduce federal deficits over time.” ...

By the same token, he said, Asian countries needed to rely less on exports and more on their consumption at home for their economic growth. One way to increase Asian household consumption, he said, would be for countries like China to increase social insurance programs and reduced the uncertainty that currently hangs over many consumers. ...

With the Asian economy expanding at an annualized rate of 9 percent in the second quarter of this year, and China’s economy expanding at rates of more than 10 percent, Mr. Bernanke said, “Asia appears to be leading the global recovery.”

But the Fed chairman warned that the United States-led crisis was fueled in large part by huge inflows of cheap money to the United States from countries like China that were trying to recycle dollars from their huge trade surpluses.

The Fed chairman noted that global trade and financial imbalances have narrowed considerably since the crisis began... But he cautioned that the imbalances could widen out again as economic growth revives. While the United States has to tighten its belt by saving more and consuming less, China and other Asian countries need to increase their consumer spending in order to promote faster domestic economic growth.

Mr. Bernanke avoided what was in many ways the elephant in the room: the value of the United States dollar. The dollar has dropped sharply in recent weeks against the euro and the Japanese yen, which has helped increase American exports by making them cheaper in some foreign markets. But the dollar has not budged in more than a year against China’s renmimbi...

Homework #3

Homework #3
Due Tuesday 10/27 at the end of class.

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 simple multiplier formula to calculate the total fall in bank deposits.

2. Derive the money multiplier when C ≠ 0 and ER ≠ 0. Explain why it is smaller than the simple money multiplier.

3. Explain the shape of the reserve demand curve. (b) Explain the shape of the reserve supply curve.

4. Use reserve supply and demand diagrams to show how (a) open market operations, (b) borrowing from the Fed, and (c) changes in reserve requirements impact the federal funds rate.

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

6. Show how the Fed's operating procedure reduces the variability in the federal funds rate.

Class Materials for Lecture 6

Brief Outline of Topics Covered in Lecture 6

Chapter 14 Multiple Deposit Creation and the Money Supply Process

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, MB_n
• 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

Video:

Additional Reading:

• Targeted liquidity operations - Econbrowser
• Fed slacker fightback - FT Alphaville
• Q&A: John Taylor on His Rule and Fed’s Balance Sheet - Real Time Economics
• Tightening the Bankruptcy Laws in the Midst of a Deep Recession - Credit Slips
• Charter Cities debate, round 2 0 - Chris Blattman
• The Economic Effects of Reduced Greenhouse-Gas Emissions - CBO Director’s Blog
• The fear of depleting international reserves - voxeu.org
• Retail Sales Tumble From Armageddon ‘08 - Market Talk
• Saving labor - MIT News
• Against the common gouda - MIT News
• How low is 1.48 (USD/EUR)? - Antonio Fatas
• Yes, We Can--Afford More Short-Run Deficit Spending, That Is - Brad DeLong
• The effectiveness of central bank swaps as a crisis-fighting tool - voxeu.org
• Reducing Incentives for Risk-Taking - Lucian Bebchuk
• Some Lessons from the Crisis - Federal Reserve Bank of New York
• A Long, Melancholy Roar - Olivia Judson
• G20 leaders must back up their rhetoric with deeds - Economists' Forum
• HealthGrades: 52 percent lower chance of dying at top-rated hospitals - EurekAlert

Application:

Fed Officials Question Expansion’s Durability, Discuss More Aid,by Craig Torres, Bloomberg: Federal Reserve policy makers doubted the durability of the recovery and for the first time signaled they were open to boosting purchases of mortgage bonds to further prop up the housing market.

Some Federal Open Market Committee members argued that expanding their purchases above $1.25 trillion might help to “reduce economic slack more quickly,” according to minutes of the Federal Open Market Committee’s Sept. 22-23 meeting released yesterday in Washington.

Policy makers considered a relapse into recession a bigger risk than a near-term rise in prices, the minutes show. They predicted “cautious” consumer spending, business investment and hiring. If those conditions persist into 2010, the Fed may extend the housing-debt purchase program beyond its current March 31 end-date, economists said. ...

In the September meeting, Chairman Ben S. Bernanke and his fellow policy makers decided to slow purchases of mortgage securities to avoid disrupting the housing market while extending the duration of the program by three months. The Fed is also buying $200 billion of housing agency debt.

At the same time, policy makers repeated their pledge to keep interest rates low for “an extended period.” The Fed has made the purchase of securities a leading monetary policy tool.

Central bankers in last month’s meeting raised their economic projections based on improved housing markets, stabilizing consumer spending and a recovery in growth outside the U.S., the minutes said.

Even so, “many participants noted that the economic recovery was likely to be quite restrained,” the minutes said. “Credit from banks remained difficult to obtain and costly for many borrowers; these conditions were expected to improve only gradually.” ...

The U.S. central bank is the largest buyer of securitized mortgages issued by Fannie Mae and Freddie Mac, purchasing 79.5 percent of new issuance in August, according to the Mortgage Bankers Association.

Fed purchases of mortgage securities have helped push down interest rates on mortgages, making it cheaper for Americans to buy a home. ... Economists’ estimates of how much the Fed’s retreat from the mortgage-bond purchase program will raise borrowing costs vary from a quarter-point to more than a percentage point, said Julia Coronado, senior economist at BNP Paribas in New York.

“The big question here is, where are mortgage rates going to go if and when the Fed walks away?” said Coronado. “There are people on the committee that are unsure. They are worried about the sustainability of the recovery.”

FOMC members “discussed the importance of maintaining flexibility to expand the asset purchase programs should the economic outlook deteriorate or to scale back the programs should economic and financial conditions improve more than anticipated,” the minutes said.

Policy makers in recent speeches have been debating the timing and conditions for an exit from the central bank’s unprecedented intervention into the economy. ...

Class Materials for Lecture 5

Brief Outline of Topics Covered in Lecture 5

Chapter 13 Structure of Central Banks and the Federal Reserve System [continued]

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

Chapter 14 Multiple Deposit Creation and the Money Supply Process

Three 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

The Money Supply Model and the Money Multiplier

• Deriving the Money Multiplier

Video:

Materials from class:

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.

Additional Reading:

• On Stimulus Spending, Deficit Hawks' Concern Is Misplaced - Johnson and Kwak
• Credit Vise Tightens for Small and Midsize Businesses - NYTimes.com
• Summers Letter Defends Stimulus - Real Time Economics
• Two Views: Blame It on Beijing Redux, or Joint Determination - Econbrowser
• Unusual Spider Species Passes Up Live Prey for Plants - Scientific American
• Can a government encourage economic experiments? - Virulent Word of Mouse
• Is international activism increasing child labour? - voxeu.org
• When should the Fed raise rates? (even more wonkish) - Paul Krugman
• China’s Dollar Problem - Kenneth Rogoff
• Alternative Measures of the Unemployment Rate - FRB Cleveland
• Small Banks Fail at Growing Rate, Straining F.D.I.C. - NYTimes.com
• The Availability and Profitability of Credit Cards - FRB Cleveland
• The Effects of “Cash for Clunkers” on the Auto Industry - FRB Cleveland
• Trade Picture Worsens in August - BusinessWeek
• The United States Trade Deficit Shrank in August - NYTimes.com
• The Fed Doesn’t Really Understand Asset Bubbles - Economix

Application:

The Misplaced Tough-Mindedness of National-Debt Hawks, by Simon Johnson and James Kwak, Commentary, Washington Post: The editorial page of this newspaper on Sunday came out against using additional fiscal stimulus to boost national output and reduce the growth rate of unemployment. The basic argument, made in qualitative terms, was that the costs of the incremental national debt would outweigh the benefits in additional output and well-being for the people benefited. ...

Ever since the early Clinton administration, the sophisticated, hard-headed thing has been to say that deficits matter. Bill Clinton and Robert Rubin made the case that if you care about national prosperity and social welfare, you have to balance the budget, which has the effect of reducing interest rates. ...

Today, we face the largest federal government deficits since World War II and our fiscal position is likely to only get worse as the population ages, Social Security and Medicare expenditures increase, and our creaky pension system springs more leaks. The government also took on massive potential liabilities bailing out the financial system over the past year, which could increase the risk of inflation in the long term. The recession, which was severely deepened by the financial crisis, has also caused a steep drop in tax revenue, further increasing the national debt.

This means that we need to fix our health-care system, and that we cannot afford another financial crisis on the scale of the last one. But it has little to do with the policy question on the table: whether to spend more money to cushion the impact of the recession on the national economy and on the people suffering from it.

The textbook argument for fiscal stimulus still applies. We face a large output gap -- the difference between the amount the economy could produce and the amount it is producing -- because demand from households (for consumption) and companies (for investment) is low. The government should therefore increase spending in order to increase demand and help close the output gap. This should be balanced by lower spending or higher taxes when the economy has recovered. The fact that our baseline amount of debt has changed does not affect the validity of this principle.

The cost of additional stimulus, according to The Post's editorial, is "a higher national debt burden, which future Americans must pay off by working harder and saving more than they otherwise would have." But the idea that we are borrowing from our grandchildren is a common fallacy. As Mark Thoma pointed out in an example that is worth reading, issuing debt today is a transfer of cash from someone with savings to all the people who benefit from whatever the government spends the proceeds on; when the debt comes due -- in, say, 30 years -- there will be a transfer of cash from taxpayers to whoever is holding the bond at that point. (For example, the heirs of the person who bought the bond.) The money doesn't move from one generation to another.

But what about China? Aren't we borrowing money from China? Yes, but at the margin, we as a country (combining households, businesses and the government) are getting the money at a very low interest rate that we don't have to pay back for a long time. Now, this probably cannot go on forever -- that interest rate could start to rise -- but as Dean Baker points out, the underlying problem is that we export less than we import, which is what causes foreigners to accumulate financial claims on us.

The proper questions to ask, as with all borrowing, are whether the money is being used ... effectively..., especially when Congress is involved. But just as in the original stimulus debate early this year, there are some obvious places to start, such as extending unemployment benefits and providing direct aid to states. ...

We are not saying that we should simply ignore the national debt. But the best way to address the debt is to make a binding commitment now to raise taxes in the future when the economy recovers. The second-best way is to pass health-care reform that has a reasonable chance at reducing the growth rate of health costs. And the third-best way is to reform the financial system to minimize the chances of and the potential damage caused by another financial crisis. Using the national-debt bogeyman to avoid taking obvious steps to combat the recession and helping its victims is misplaced tough-mindedness.

Homework #2

Homework #2
Due 10/15 at the end of class

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

2. 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?

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

4. Discuss arguments for and against the independence of the Fed.

5. Does the Fed have better control over reserves or the monetary base? Explain.

6. 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.  [This problem has been omitted from this assignment since we didn't get to this material. If you did the problem already, note that it will be on the next homework.]

Class Materials for Lecture 4

Brief Outline of Topics Covered in Lecture 4

Chapter 12 Structure of Central Banks and the Federal Reserve System [continued]

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

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

Video:

Materials from class:

none for today

Additional Reading:

• Answering Your Questions on the Economy - Paul Krugman
• To trust or not to trust - voxeu.org
• U.S. Begins Antitrust Inquiry of I.B.M. in Mainframes - NYTimes.com
• International Economic Update - FRB Dallas
• Will stimulating nominal aggregate demand solve our problems? - Econbrowser
• Future Research in Finance - Rortybomb
• Prospects for a small business-fueled employment recovery - macroblog
• Support Builds for a Tax Credit for Creating Jobs - NYTimes.com
• Jeffrey Sachs Rails against Ex-Fed Chief Greenspan - Real Time Economics
• For the Cartels, an Economic Battle - washingtonpost.com
• Illusions: What's in a face? - Scientific American
• Paralysis in the Debt Markets Is Deepening the Credit Drought - NYTimes.com
• Australia raises rates from 49-year low - FT.com

Application:

3 Questions: Robert Solow on the struggle ahead, MIT News: Economist Robert Solow's seminal work in the 1950s and 1960s showed how new technologies create a large portion of economic growth, an achievement for which he was awarded the 1987 Nobel Prize in Economics. With the economy seemingly in need of a technological boost again, the emeritus Institute Professor sat down with MIT News for a talk in his office this week.

Q. What is your assessment of the economy now, and where is it going?
A. Forecasting is hard and dangerous, and I don't do it. But it appears that the worst of the recession is over. However, the economy will be getting better slowly. And saying the economy is getting better is not the same thing as saying the economy is doing well. Real GDP fell by about 3.5 percent during the recession. But capacity increased 2.5 percent. We were producing 6 percent less than we knew how to produce. That gap has to narrow to reduce unemployment. If we rely only on the normal self-curing powers of a market economy, it may take until late in 2010 or early 2011 before we reduce that gap. So for that reason we should not rule out further stimulus in the next six to nine months. It's not easy because we have this enormous deficit. But we should recognize that even if the economy improves on its own, it won't do very much.

I had hoped that President Obama at the beginning of his term, while his popularity was at its highest, would have taken a very strong line. I don't think he could have asked for $1.4 trillion in stimulus, but he could have had a slightly bigger and better package, had he bullied a little bit more. If Obama or [David] Axelrod were to reply, "Boy, are you naïve," about the politics, I don't think I could have answered that. I'm just saying what I think God would have done if God were making these decisions. Congress falls well short of God.

Q. Your research made clear how much technology can contribute to economic growth. To what extent might we see technology driving growth now?
A. I actually think the situation of the economy calls for a surge in technologically oriented investment. We have to expect consumer spending to be weak in our economy, not just for six months, but for the next few years. It will not be as strong a driving force as it has been the past several years. Something has to take its place. Government spending can't, since government will have a hard time financing the inevitable deficits and is not in a position to aggressively increase its deficit spending.

That leaves two sources of expenditure to replace the pullback of consumers. One of those is net exports. That's a long story. The other is business investment. We need business investment to support the economy. We have every reason to want to divert our resources toward secure and renewable sources of energy, new materials and environmental improvement. It's our job, a place like MIT, to produce those new technologies, then it's the job of private industry to grab them, but I also think it's the job of the federal government to shift incentives, from incentives to consume more to incentives to invest more. Obama ran on this kind of platform, and if he can put some money behind that fundamentally correct view, he might generate something. It's going to take more than that to replace 5 percent of GDP, but that would be a neat place to start.

Q. In 2005 you wrote that you were "disaffected" by the "assumptions and methods" of macroeconomics. There has been a lot of debate about this subject in the last month. What is your assessment of the state of macroeconomics now?
A. The disaffection I expressed is still my assessment. The beast [the economic crisis] expressed the same disaffection in 2007 and 2008, and the currently fashionable way of doing macroeconomics in the profession literally had nothing to offer in response. The problem as I have thought about it is that currently fashionable macroeconomics likes to formulate things in a way that inevitably endows the economy with more coherence and purpose than we have any right to assume. I certainly hope this is obvious enough to the younger people in the profession, the graduate students and even junior faculty. I expect there will be a revival of doing macroeconomics that does not push that kind of coherence on aggregate economic behavior. Which is not to say that some individuals don't behave in a coherent way, but the system does not translate that behavior into something like a super-individual.

• Answering Your Questions on the Economy - Paul Krugman
• To trust or not to trust - voxeu.org
• U.S. Begins Antitrust Inquiry of I.B.M. in Mainframes - NYTimes.com
• International Economic Update - FRB Dallas
• Will stimulating nominal aggregate demand solve our problems? - Econbrowser
• Future Research in Finance - Rortybomb
• Prospects for a small business-fueled employment recovery - macroblog
• Support Builds for a Tax Credit for Creating Jobs - NYTimes.com
• Jeffrey Sachs Rails against Ex-Fed Chief Greenspan - Real Time Economics
• For the Cartels, an Economic Battle - washingtonpost.com
• Illusions: What's in a face? - Scientific American
• Paralysis in the Debt Markets Is Deepening the Credit Drought - NYTimes.com
• Australia raises rates from 49-year low - FT.com

I had hoped that President Obama at the beginning of his term, while his popularity was at its highest, would have taken a very strong line. I don't think he could have asked for $1.4 trillion in stimulus, but he could have had a slightly bigger and better package, had he bullied a little bit more. If Obama or [David] Axelrod were to reply, "Boy, are you naïve," about the politics, I don't think I could have answered that. I'm just saying what I think God would have done if God were making these decisions. Congress falls well short of God.

Q. Your research made clear how much technology can contribute to economic growth. To what extent might we see technology driving growth now?
A. I actually think the situation of the economy calls for a surge in technologically oriented investment. We have to expect consumer spending to be weak in our economy, not just for six months, but for the next few years. It will not be as strong a driving force as it has been the past several years. Something has to take its place. Government spending can't, since government will have a hard time financing the inevitable deficits and is not in a position to aggressively increase its deficit spending.

That leaves two sources of expenditure to replace the pullback of consumers. One of those is net exports. That's a long story. The other is business investment. We need business investment to support the economy. We have every reason to want to divert our resources toward secure and renewable sources of energy, new materials and environmental improvement. It's our job, a place like MIT, to produce those new technologies, then it's the job of private industry to grab them, but I also think it's the job of the federal government to shift incentives, from incentives to consume more to incentives to invest more. Obama ran on this kind of platform, and if he can put some money behind that fundamentally correct view, he might generate something. It's going to take more than that to replace 5 percent of GDP, but that would be a neat place to start.

Q. In 2005 you wrote that you were "disaffected" by the "assumptions and methods" of macroeconomics. There has been a lot of debate about this subject in the last month. What is your assessment of the state of macroeconomics now?
A. The disaffection I expressed is still my assessment. The beast [the economic crisis] expressed the same disaffection in 2007 and 2008, and the currently fashionable way of doing macroeconomics in the profession literally had nothing to offer in response. The problem as I have thought about it is that currently fashionable macroeconomics likes to formulate things in a way that inevitably endows the economy with more coherence and purpose than we have any right to assume. I certainly hope this is obvious enough to the younger people in the profession, the graduate students and even junior faculty. I expect there will be a revival of doing macroeconomics that does not push that kind of coherence on aggregate economic behavior. Which is not to say that some individuals don't behave in a coherent way, but the system does not translate that behavior into something like a super-individual.

• Answering Your Questions on the Economy - Paul Krugman
• To trust or not to trust - voxeu.org
• U.S. Begins Antitrust Inquiry of I.B.M. in Mainframes - NYTimes.com
• International Economic Update - FRB Dallas
• Will stimulating nominal aggregate demand solve our problems? - Econbrowser
• Future Research in Finance - Rortybomb
• Prospects for a small business-fueled employment recovery - macroblog
• Support Builds for a Tax Credit for Creating Jobs - NYTimes.com
• Jeffrey Sachs Rails against Ex-Fed Chief Greenspan - Real Time Economics
• For the Cartels, an Economic Battle - washingtonpost.com
• Illusions: What's in a face? - Scientific American
• Paralysis in the Debt Markets Is Deepening the Credit Drought - NYTimes.com
• Australia raises rates from 49-year low - FT.com

Class Materials for Lecture 3

Brief Outline of Topics Covered in Lecture 3

Chapter 5 The Behavior of Interest Rates

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
• 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

Materials from class:

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

Video:

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.

Additional Reading:

• Toles - Washington Post
• Disagreement about the Inflation Outlook - FRBSF Economic Letter
• Should the government intervene to reduce obesity? - voxeu.org
• Cap-and-Trade versus the Alternatives for U.S. Climate Policy - Robert Stavins
• New York Fed’s Dudley: Fed Won’t Raise Rates Soon - Real Time Economics
• Capital market theory after the efficient market hypothesis - voxeu.org
• Greenspan Takes Measure of the Economy - Real Time Economics
• Paul Romer on Charter Cities - Aid Watch
• Public-Private Investment Program Almost Ready to Begin - NYTimes.com
• Larry Summers and the White House economic team - The New Yorker
• Economic troughs, unemployment, and fed policy - macroblog
• More on the medium-term outlook for the recovery - Antonio Fatas
• In Defense of Forecasting - Economix
• Fed Chest-Thumping for Beginners - The Baseline Scenario
• Multipliers, Reviewed - Econbrowser

Application:

What happens to innovation, technology and growth during recessions? Are recessions temporary, or do they have a permanent impact on the trend rate of output? Antonio Fatás says "one cannot reject the hypothesis that all output fluctuations leave a permanent scar in the economy," but these questions deserve "more attention in terms of academic research":

More on the medium-term outlook for the recovery, by Antonio Fatás: The magazine The Economist has an article this week on the persistence of the current recession and whether output will return to its trend. The arguments that the article present are similar to those made in the Chapter 4 of the recent World Economic Outlook by the IMF (see our previous post on this matter): it is likely that the current recovery is not strong enough to bring output back to trend. In a recent NBER working paper, Cechetti, Kohler and Upper also provide empirical evidence suggesting that financial crisis leave long-lasting (negative) effects on output.

The question on the connection between recessions (or business cycles in general) and potential output ("the trend") is one that has not been studied much in economics. Most of the models we use tend to think about the trend as being independent of business cycles - so recoveries always bring output back to the pre-crisis trend. Policy makers tend to use the concept of the output gap, the deviation of output from its potential, to think about the strength of the recovery under the assumption that in a "normal" year the output gap should be back to zero.

The strongest evidence one can find in favor of this hypothesis (that recessions are temporary) comes from the US economy. The US economy has displayed a surprising tendency to return to trend even after some major events such as the great depression, World War II or the recessions of the 70s. Below you can see a chart that shows the evolution of GDP per capita in the US during the period 1870-2008. The red line represents a (log-)linear trend using data up to 1928. It is remarkable how close the blue line is to the red line and how the economy recovers to return to trend.

In fact, using 1870-1928 data, a prediction using that (log-)linear trend leads to an error of only 1% for the level of GDP per capita in 2008. Of course, the picture is misleading in the sense that in some cases it took a long time for the economy to come back to this trend, but it is still interesting that it returned to the same trend. It could have returned to the same growth rate but at a different level but that's not what we see, we see that the output loss is always recovered after a number of years. This suggests that the supply side of the economy (innovation, technology) is unaffected by output fluctuations.

If one looks more carefully at the data, the evidence becomes much weaker. In contradiction to what we see in the picture above, empirical economists know that output fluctuations are very persistent. In fact, one cannot reject the hypothesis that all output fluctuations leave a permanent scar in the economy. If we suffer a recession, output never goes back to trend, it remains at a lower level forever (this is what is known in the academic literature as the existence of a "unit root" in output).

From a theoretical point of view, there are two ways to justify the fact that recessions always leave permanent effects:

1. Technological changes are the cause of business cycles. Recessions are period where we are not good at innovating and this causes both a recession and a permanent loss in output. This is what we know as "real business cycle theory".

2. Innovation is affected by recessions. During recessions firms invest less and this lead to a temporary slowdown of technological progress, so the economy never returns to the same trend. It will go back to its normal growth rate but the temporary effects on growth will leave a permanent scar on the economy. This is the argument that we hear these days to support the fear that the current recovery will not be strong enough. A few years ago I wrote a couple of academic papers that presented this theory and some international evidence in favor of this hypothesis (the papers can be found here and here). This is an area of macroeconomics that I believe deserves more attention in terms of academic research (but I am biased, given that I have written on the subject). And it is not just about financial crisis but, more generally, about what happens to innovation, technology and growth during recessions.

Do Regulators Have Distorted Incentives?

For anyone who might be interested, here's the roundtable discussion at The Economist I mentioned yesterday in class. The lead article by Beatrice Weder di Mauro argues that regulators need better incentives:

• The dog that didn't bark, by Beatrice Weder di Mauro

Here's my response:

• Prioroties at the Top, by Mark Thoma

Here are other responses:

• Devil in the details, by Charles Goodhart
• No perfect solution, by Daron Acemoglu
• The Danger of Capture, by Simon Johnson
• Remove the culpable, by Raghuram Rajan
• Better Regulators Needed, by Harvey Pitt
• Uncomfortable Institutions, by Tyler Cowen
• Not just a failure of markets, by Albert Alesina

Homework #1

Economics 470/570
Fall 2009
Due: End of class on Thursday, 10/8

1. Suppose that there are 10 individuals, each with $10,000 in savings that they would like to lend, but only if there is little to no chance that they will lose their investment. Suppose there are also 10 different people who want to take out $10,000 loans. (a) Assuming an expected default rate of 10% and an interest rate on loans of 20%, use this example to show how pooling risk through financial intermediation can increase the efficiency of financial markets. (b) Assuming the default rate using financial intermediation is exactly 10%, what is the interest rate at which the return is 0%?

2. Suppose that there are 10 individuals, each with $10,000 in savings that they would like to lend. Suppose there another person who wants to take out a $100,000 loan. 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 20% 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, none of them 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?

6. 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.