Economics 470/570 - Monetary Theory and Policy

Class Materials for Lecture 16 (Tuesday 11/30)

Brief Outline of Topics Covered in Lecture 16

Chapter 25 Rational Expectations and Implications for Policy [cont.]

• New Classical Macroeconomics Model
  • Effects of unanticipated and anticipated policy
  • Can an expansionary policy lead to a decline in aggregate output?
  • Policy ineffectiveness and implications for policymakers

• New Keynesian Model
  • Effects of unanticipated and anticipated policy
  • Implications for policymakers

• Comparisons of New Classical, New Keynesian, and Traditional Keynesian Models 
  • Short-Run Output and Price Responses

Video:

Materials from class:

Additional Reading: 

• Ben Bernanke, the Fed, and quantitative easing - James Surowiecki
• F.D.I.C. Says Hundreds of Small Lenders Remain at Risk - NYTimes.com
• Fed lowers economic expectations for 2011 - washingtonpost.com
• Thoughts on QE2 - Robert Barro
• The nerve center of the Treasury Department - washingtonpost.com
• Two percent or a bit below - Antonio Fatas
• Peak oil in Pennsylvania - Econbrowser
• Federal Reserve policies focused - macroblog
• Fed Weighed Setting Inflation Target, Minutes Show - NYTimes.com
• Fed Adopts Political Tactics to Fight Critics - NYTimes.com
• The Fed's communication problem - Econbrowser
• Behind the Numbers: PCE Inflation Update - FRB Dallas

Application:

TARP is expected to cost $25 billion:

 

TARP expected to cost U.S. only $25 billion, CBO says, by Lori Montgomery, Washington Post: The Troubled Asset Relief Program, which was widely reviled as a $700 billion bailout for Wall Street titans, is now expected to cost the federal government a mere $25 billion...

A new report released Monday by the nonpartisan Congressional Budget Office found that the cost of the program, known as TARP, has plummeted since its passage in October 2008, when policymakers thought that the world stood on the brink of an economic meltdown.

"Clearly, it was not apparent when the TARP was created two years ago that the cost would turn out to be this low," the CBO report says. ...

The TARP was conceived in the final days of the Bush administration and pushed through a reluctant Congress in less than three weeks. It is widely thought to have helped stabilize a financial sector on the verge of collapse, though it remains hugely unpopular with the public. ...

All told, $389 billion has been distributed through the TARP, which expired in October. The CBO estimates that an additional $44 billion is still waiting to go out the door, primarily to troubled insurance giant American International Group and federal mortgage programs. That would bring total TARP outlays to $433 billion, of which about half - $216 billion - has been repaid.

The rest of the TARP investments, meanwhile, have become markedly less risky, according to the CBO, and in many cases even profitable. ...

While the cost of the TARP is coming in far below expectations, it is just one of several massive government programs aimed at propping up the financial industry. The Federal Reserve and the FDIC have together guaranteed billions of dollars in bank debt. 

 

Review Questions for the Final

These questions are for the topics we covered after the midterm. The review materials for the topics covered before the midterm are here (the final is comprehensive).

Definitions

Consumption, disposable income, MPC and MPS
Investment
Government spending
Aggregate demand or expenditures
Expenditure multiplier
IS curve
LM curve
Policy effectiveness
Crowding out
Potential or natural rate of output
Short-run aggregate supply
Long-run aggregate supply
Debt monetization
Inflation
Cost push inflation
Demand pull inflation
Activist/non-activist
Data lag
Recognition lag
Legislative lag
Implementation lag
Effectiveness lag
Monetary neutrality
Rational expectations
Price rigidity

Essay

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

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

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

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

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

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

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

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

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

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

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

12. Explain Poole's rules.

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

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

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

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

17. Is the economy self-correcting? 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?

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

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

20. Can budget deficits lead to inflation? Explain.

21. What is debt monetization? Why might governments choose to monetize the debt?

22. Explain and give an example of the Lucas critique. Why is this important?

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

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

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

26. 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.

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

Class Materials for Lecture 15 (Tuesday 11/23)

Brief Outline of Topics Covered in Lecture 15

Chapter 24 Money and Inflation (cont.)

The activist/non-activist debate

• Policy lags and other problems in pursuing activist policies

Chapter 25 Rational Expectations and Implications for Policy

RE and the Lucas critique

New Classical Macroeconomics Model

• Effects of unanticipated and anticipated policy
• Can an expansionary policy lead to a decline in aggregate output?
• Policy ineffectiveness and implications for policymakers

Video:

Materials from class:

none this time

Additional Reading:

• Just how does policy work? - macroblog
• After QE2, Watching Inflation’s Trajectory - NYTimes.com
• Good riddance CCX - Environmental Economics
• When is regulation more efficient than competition? - voxeu.org
• Ride, Bernanke, Ride - Paul Krugman
• Foley, Sidrauski, and the Microfoundations Project - Rajiv Sethi
• Criticism Hinders Fed's Easing Plan - WSJ.com
• Japan's Monetary Policies Provide History Lesson - WSJ.com
• Kicking the Fed - washingtonpost.com

Application:

This is something I wrote last Wednesday:

Interest on Reserves and Inflation: There's been a lot of talk lately about the Fed's policy of paying interest on reserves with many claiming that this has caused banks to retain reserves that might have otherwise been turned into loans, and thus the policy has depressed aggregate activity. However, paying interest on reserves is a safety net for the Fed that allowed them to do QEI and QEII. If the Fed wasn't paying interest on reserves, QEI would have likely been smaller, and QEII may not have happened at all.

First, on whether paying interest on reserves is a constraint on loan activity, the supply of loans is not the constraining factor, it's the demand. Increasing the supply of loans won't have much of an impact if firms aren't interested in making new investments. Businesses are already sitting on mountains of cash they could use for this purpose, but they aren't using the accumulated funds to make new investments and it's not clear how making more cash available will change that.

Second, I doubt very much that a quarter of a percentage interest -- the amount the Fed pays on reserves -- is much of a disincentive to lending (market rates have fluctuated by more than a quarter of a percent without a having much of an impact on investment and consumption).

Third, this a safety net for the Fed with respect to inflation. Paying interest on reserves gives the Fed control over reserves they wouldn't have otherwise, and control of reserves is essential in keeping inflation under control. If, as the economy begins to recover, the Fed loses control of reserves and they begin to leave the banks and turn into investment and consumption at too fast a rate, then inflation could become a problem. 

But by changing the interest rate on reserves, the Fed can control the rate at which reserves exit banks. The incentive to loan money is the difference between what the bank can earn by loaning the money or purchasing a financial asset and what it can make by holding the money as reserves. Suppose, for example, that the Fed raises the interest rate on reserves to the market rate of interest. In that case, banks would have no incentive at all to make loans and would instead just hold the reserves.

The tool the Fed has for removing reserves from the system is open market operations (QEI and QEII are essentially traditional open market operations, but the Fed buys long-term rather than the more traditional short-term financial assets). So why do they need another tool -- interest on reserves -- to control reserves? Removing reserves too fast through open market operations could disrupt financial markets. Paying interest on reserves gives the Fed a way to remove reserves in a more leisurely fashion while still maintaining control over inflation. They can raise the interest rate on reserves freezing them within the banking system, and then remove the reserves over time through open market operations as desired.

To say this another way, traditionally the only way the Fed could raise the federal funds rate is through open market operations that remove reserves from the system. However, since interest on reserves is a floor for the federal funds rate (it's a floor because nobody would lend reserves at a rate less than they can earn by holding them), an increase in the rate the Fed pays on reserves will increase the federal funds rate even though the reserves are still in the system. The economy can be slowed through increases in the federal funds rate without having to remove substantial quantities of reserves all at once as would be the case if open market operations were the only tool available.

Thus, though I don't think paying interest on reserves has much of an effect on loan activity right now, even if you believe it has, this is the price that must be paid for the ability to do QEI and QEII. If the Fed did not have this tool available, it would be much more fearful about its ability to control inflation, and much less likely to try to use unconventional policy to spur the economy.

Update: In comments, Andy Harless correctly points out that the Fed could cut the rate it pays on reserves to zero now, but still have the authority to raise rates later as necessary to help to fight inflation.  As I noted in a reply to Andy, I agree, but the Fed does not -- I meant to, but forgot to include Bernanke's worries that cutting the rate to zero would cause problems in the federal funds market. Bernanke's argument is:

“The rationale for not going all the way to zero has been that we want the short-term money markets, like the federal funds market, to continue to function in a reasonable way,” he said.

“Because if rates go to zero, there will be no incentive for buying and selling federal funds — overnight money in the banking system — and if that market shuts down … it’ll be more difficult to manage short-term interest rates when the Federal Reserve begins to tighten policy at some point in the future.”

The argument itself is a bit hard to swallow and I don't buy it, prior to the recession the rate was zero and the markets functioned fine. But from the Fed's perspective that doesn't matter -- they seem to believe that it is necessary to pay something on reserves to prevent problems in the overnight market for reserves. Thus, in the Fed's view, paying a quarter of a percent right now is a necessary part of this policy, a policy that gives them the comfort they need to employ quantitative easing. The Fed may or may not be correct about the impact on the overnight federal funds market, but it holds all the cards and as a practical matter, if you want QEII, then this is part of the bargain.

Class Materials for Lecture 14 (Thursday 11/18)

Brief Outline of Topics Covered in Lecture 14

Chapter 24 Money and Inflation (cont.)

How does inflationary policy arise?

• Cost push - demand for higher wages
• Demand pull - shooting at the wrong target
• Budget deficits and inflation

The activist/non-activist debate

• Policy lags and other problems in pursuing activist policies

Chapter 25 Rational Expectations and Implications for Policy

RE and the Lucas critique

New Classical Macroeconomics Model

• Effects of unanticipated and anticipated policy
• Can an expansionary policy lead to a decline in aggregate output?
• Policy ineffectiveness and implications for policymakers

Video:

Materials from class:

Additional Reading:

• That QEII Letter From Economics 21 - Rortybomb
• How negative should real interest rates be? - Antonio Fatas
• Unemployment and happiness - voxeu.org
• More From Evans and Rosengren on Fed Policy - Real Time Economics
• Industrial Production, Capacity Utilization Flat in October - Calculated Risk
• Economics Offers Tactics, Not Strategy - Ed Glaeser
• New York Fed President Defends Bond Buying Plan - NYTimes.com
• GOP Criticism Of The Fed: Predictable and Predicted - Stan Collender
• Scientists witness the apparent birth of a black hole - Washington Post
• San Francisco Fed Official Says QE2 Is Working - Real Time Economics
• The Economic Outlook - John C. Williams
• Diamond a test of QE2 opposition - Money Supply
• Fed’s Lacker Sees Inflation Risk as Jobless Rate Remains High - RTE

Application:

What is QEII, by Mark Thoma, CBS MoneyWatch: What is QEII? Quantitative easing, which the Fed has done once already (known as QEI) and is about to do again (QEII), can be understood through a device called the yield curve. The yield curve shows how the expected return on financial assets changes with differences in the maturity of the assets:

The horizontal axis shows the time to maturity, with overnight financial assets such as the federal funds market on the left and 30 year assets such as mortgages on the right. Other maturities, e.g. 3 month, 6 month, one year, 5 years, 10 years, 20 years, etc., lie between these values. The vertical axis shows the expected return on the assets. The curve generally slopes upward due to the extra return that is required to induce people to tie their money up for longer and longer periods of time.

Prior to the housing bubble, the Fed was able to shift the entire yield curve up and down by buying and selling short-term Treasury bills. Thus, the Fed had control of both long-term and short-term interest rates:

However, during the housing bubble but prior to its collapse, the Fed seemed to lose control over the long end of the yield curve. Buying and selling short-term T-Bills no longer seemed to have much impact on long-term interest rates:

Since it is predominantly long-term rates that determine business investment, the purchase of new homes, and the purchase of consumer durables such as cars and refrigerators, this was of concern within the Fed. But the reason for this was never fully understood, and the crisis diverted attention away from this issue. However, one way the Fed can potentially overcome this problem is to buy and sell longer term Treasury bonds, i.e. those that exist on the long end of the yield curve, to bring long term rates up or down as desired.

This is, essentially, all that QEII is. It is conventional monetary policy that operates at the long end of the yield curve through the buying and selling of long-term financial assets rather than through the more traditional buying and selling of short-term assets.

However, the need to operate at the long end of the yield curve presently is not because the Fed has lost control of long-term rates as it seemed to prior to the crisis -- that control returned once the bubble popped. It's because the Fed can no longer move rates at the short-end.

Presently, the Fed cannot operate at the short end of the yield curve because the short-term rate the Fed generally targets –- the overnight federal funds rate -- is at or very near zero. Operating at the short-end of the yield curve doesn’t do much good since those rates can’t come down any further. However, the Fed can still bring down rates at the long-end:

The hope is that the fall in rates at the long end will spur new investment and consumption (along with other effects such as an increase in net exports due to a fall in the exchange rate, though see here for a denial that the Fed is intending to change the value of the dollar with QEII).

So that’s QEII. It’s nothing more than conventional monetary policy moved out along the yield curve.

Homework #6

Economics 470
Fall 2010
Homework 6
Due Tuesday, November 23

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

2. Show graphically that monetary and fiscal policy have no long-run effect on output when prices are allowed to vary. Be sure to explain what the graph shows.

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

4. Why does the SRAS slope upward? Why is the LRAS vertical?

5. Explain debt monetization. Explain why debt monetization can be automatic when the Fed follows an interest rate rule for monetary policy (this can be done graphically). Is this a problem right now?

Class Materials for Lecture 13 (Tuesday 11/16)

Brief Outline of Topics Covered in Lecture 13

Chapter 22 Aggregate Demand and Supply Analysis

Aggregate supply

• Aggregate supply in the short-run
• Aggregate supply in the long-run

Equilibrium

• Does the economy self-correct?

Chapter 24 Money and Inflation

 Inflation

• Monetarist view
• Keynesian view
• Supply shocks
• Always a monetary phenomena?

How does inflationary policy arise?

• Cost push - demand for higher wages
• Demand pull - shooting at the wrong target
• Budget deficits and inflation

Video:

Materials from Class:

Additional Reading:

• In Defense of Ben Bernanke - Alan Blinder
• The historical roots of inequality: Evidence from slavery - voxeu
• Can the economy be saved? - latimes.com
• What Should Macroeconomics Do? - Brad DeLong
• Fed's Raskin: Mortgage Servicing Needs Serious Reform - RTE
• Even the Greenspan Fed Was No Politburo - Real Time Economics

Application:

 Myths about the Fed, by Greg Ip, Washington Post: ...By printing money, the Fed will create runaway inflation. The Nobel Prize-winning economist Milton Friedman issued a famous dictum nearly 50 years ago: "Inflation is always and everywhere a monetary phenomenon." His belief has become widespread over the years, to the point that even many non-economists assume that when the Fed prints money, higher prices inevitably result. But the link between money and inflation is weaker than people think.

The Fed's current policy of "quantitative easing"essentially means it is printing money ($600 billion) to buy assets such as government bonds. The Fed isn't literally printing the $20 bills that end up in your wallet - it's doing the electronic equivalent. When it buys a $100 bond from a bank, it deposits $100 into the bank's account at the Fed. This electronic money is called reserves, and the Fed conjures it up out of thin air.

However, this money can lead to inflation only if banks lend it and consumers and businesses spend it. Banks lend when they have strong balance sheets and when credit-worthy customers demand loans. People and businesses spend when their incomes are growing and they're confident about the future. None of this has been true lately.

The Fed is trying to stimulate spending, but not by showering people with newly minted dollars. Rather, when the Fed buys bonds, it pushes their prices up and their yields down. Lower long-term interest rates will tempt some people to borrow. They will also make stocks more attractive. Higher stock prices will make consumers feel wealthier and spend more. If that spending outstrips the economy's productive capacity, inflation could result. But that's years away: The economy today is awash in idle factories and unemployed workers. ...

Class Materials for Lecture 12 (Thursday 11/11)

Brief Outline of Topics Covered in Lecture 12

Chapter 21 Monetary and Fiscal Policy in the IS-LM Model (cont.)

The Fed cannot control both i and M simultaneously

• Unstable IS curve
• Unstable LM curve

Poole's Pules

The IS-LM model in the long-run

• Natural rate of output
• Monetary and fiscal policy in the short-run and long-run

The aggregate demand curve

• Derive from IS-LM model
• Slope of aggregate demand curve
• Shifts in the aggregate demand curve

Chapter 22 Aggregate Demand and Supply Analysis

Aggregate supply

• Aggregate supply in the short-run
• Aggregate supply in the long-run

Equilibrium

• Does the economy self-correct?

 

Video:

Materials from Class:

Additional Reading:

• Back to a Gold Standard? - Room for Debate - NYTimes
• Gold’s ‘Record High’ in Context - David Leonhardt
• Peter Diamond Gets Another Shot at Fed Seat - Real Time Economics
• The first global recession in decades - voxeu.org
• FOMC composition and future monetary policy - FT Alphaville
• Job Openings decrease slightly, Low Labor Turnover - Calculated Risk
• Entrepreneurs of necessity - macroblog
• Inflation Delusions - Paul Krugman
• Ben Bernanke's too timid QE2 - Dean Baker
• Fed’s Warsh Skeptical on QE2 - Real Time Economics
• Fed’s Bullard: Benefits of QE2 Outweigh Risks - Real Time Economics

Application:

Gold During the Depression, NYTimes: Mark Thoma is an economics professor at the University of Oregon and blogs at Economist's View.

The ability of countries to use monetary policy to address domestic problems depends upon whether they have a fixed or floating exchange rate.

Under floating exchange rate systems, each country has the ability to set domestic monetary policy independently. However, in fixed exchange rate regimes -- as when the value of the domestic currency is fixed to the value of gold -- countries lose the ability to pursue domestic monetary policy. This is because any attempt to change the money supply to ease domestic economic problems would cause the value of the currency to change relative to gold.

Since the money supply cannot be manipulated at will, an advantage of a gold standard is that it insulates countries from inflation due to excessive money growth – a helpful constraint for countries with a history of inflation problems. The disadvantage is that monetary policy would no longer be available as a stabilization tool. Countries are forced to increase their reliance on fiscal policy, which can create its own problems.

The experience of the Great Depression shows that the loss of the use of monetary policy as a stabilization tool can be quite costly. In the 1930s, the countries that abandoned their commitment to the gold standard had much better outcomes than countries that kept the value of their currency fixed in terms of gold. In addition, historical experience with the gold standard shows that both inflation and deflation will still occur because variations in the supply and demand for gold will alter the price of gold relative to other commodities.

So the cost of giving up monetary policy is high while the benefits from price stability are not very large. So why does Robert Zoellick suggest “employing gold as an international reference point of market expectations about inflation, deflation and future currency values”? Since the gold standard is a proven bad idea, I am going to give him the benefit of doubt and assume he has something else in mind – perhaps Jeffrey Frankel’s interpretation is correct. But whatever he is suggesting, returning to the gold standard is not a policy we should pursue.

Homework #5

Economics 470
Fall 2010
Homework 5
Due Tuesday, November 16

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

2. (a) Use the 45 degree line diagram to show how the IS curve shifts when there is a decrease in taxes. (b) Show graphically that the IS curve becomes flatter when MPC increases.

3. Derive the LM curve for the case where the economy contains a liquidity trap. Show how the LM curve shifts in this case when there is an increase in the money supply.

4. Does monetary policy become more or less effective when net exports become more responsive to changes in the interest rate? Explain.

Class Materials for Lecture 11 (Tuesday 11/9)

Brief Outline of Topics Covered in Lecture 11

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

Changes in the equilibrium values of output and the interest rate

• Monetary policy in the IS-LM model
• Fiscal policy in the IS-LM model

Effectiveness of Monetary and Fiscal Policy Graphically and Intuitively

• Responsiveness of money demand to the interest rate (including liquidity trap)
• Responsiveness of investment to the interest rate

The Fed cannot control both i and M simultaneously
Poole's Pules

• Unstable IS curve
• Unstable LM curve

The IS-LM model in the long-run

• Natural rate of output
• Monetary and fiscal policy in the short-run and long-run

Video:

Class Material:

See the class materials for the lecture before this one.

Additional Reading:

• Bob Zoellick Makes His Play for the Stupidest Man Aliven - Brad DeLong
• The New Malaise and How to End It - Kevin W. Warsh
• Friedman Casts Long Shadow as Economists Meet - NYTimes.com
• Current economic conditions - Econbrowser
• Fed Hopes to Draw a Virtuous Economic Circle - NYTimes.com
• Exporting Our Way to Stability - Barack Obama
• Bernanke Defends Fed’s Buying Plan in Face of Criticism Abroad - NYT
• Electric Jolt to Brain Boosts Math Skills - National Geographic
• Empirical Questions About the Anticipation Effects of QE2 - John Taylor
• The Recession’s Toll on Long-Term Unemployment - Brookings
• Time to end the denial over mortgage debt - Reinhart and Reinhart
• Corruption as a barrier to entry - voxeu.org
• The dismal economics of paywalls - Felix Salmon
• Fed’s Hoenig on QE2 - Real Time Economics
• Has Bernanke Pleaded? - NYTimes.com
• Generating Inflation Expectations - Paul Krugman
• The Volcker Rule After the Midterm Elections - Simon Johnson

Application:

There is a lot of confusion over the Fed's use of core inflation as part of its policy making process. One reason for confusion is that we using a single measure to summarize three different definitions of the term "core inflation" based upon how it is used.

First, core inflation is used to forecast future inflation. For example, this recent paper uses a "bivariate integrated moving average ... model ... that fits the data on inflation very well," and finds that the long-run trend rate of inflation "is best gauged by focusing solely on prices excluding food and energy prices." That is, this paper finds that predictions of future inflation based upon core measures are more accurate than predictions based upon total inflation.

Second, we also use the core inflation rate to measure the current trend inflation rate. Because the inflation rate we observe contains both permanent and transitory components, the precise long-run inflation rate that consumers face going forward is not observed directly, it must be estimated. When food and energy are removed to obtain a core measure, the idea is to strip away the short-run movements thereby giving a better picture of the core or long-run inflation rate faced by households. I should note, however that this is not the only nor the best way to extract the trend and the Fed also looks at other measures of the trend inflation rate that have better statistical properties. Thus while the first use of core inflation was for forecasting future inflation rates, this use of core inflation attempts to find today's trend inflation rate [There is a way to combine the first and second uses into a single conceptual framework that encompasses both, but it seemed more intuitive to keep them separate. In both cases, the idea is to find the inflation rate that consumers are likely to face in the future.]

Let me emphasize one thing. If the question is "what is today's inflation rate," the total inflation rate is the best measure. It's intended to measure the cost of living and there's no reason at all to strip anything out. It's only when we ask different questions that different measures are used.

Third, and this is the function that is ignored most often in discussions of core inflation, but to me it is the most important of the three, it is the inflation target that best stabilizes the economy (i.e. best reduces the variation in output and employment).

In theoretical models used to study monetary policy, the procedure for setting the policy rule is to find the monetary policy rule that maximizes household welfare (by minimizing variation in variables such as output, consumption, and employment). The rule will vary by model, but it usually involves a measure of output and a measure of prices, and those measures can be in levels, rates of change, or both depending upon the particular model being examined, but generally a Taylor rule type framework comes out of this process ( i.e. a rule that links the federal funds rate to measures of output and prices).

However, in the Taylor rule, the best measure of prices is usually something that looks like a core measure of inflation. Essentially, when prices are sticky, which is the most common assumption driving the interaction between policy and movements in real variables in these models, it's best to target an index that gives most of the weight to the stickiest prices (here's an explanation as to why from a post that echoes the themes here).  That is, volatile prices such as food and energy are essentially tossed out of the index.

Another feature is that the indexes often include both output and input prices, and occasionally asset prices as well. That is, a core measure of inflation composed of just output prices isn't the best thing for policymakers to target, a more general core inflation rate combining both input and output prices works better.

The core inflation rate you see in the news, the one that strips out food and energy, should be though of as a short-hand, quick measure of all three of these concepts. But in each case the Fed uses measures (formally or informally) designed to best satisfy these three functions. For example, when it forecasts future inflation, it uses a different concept of core inflation than it uses in setting policy.

The Fed paper linked above is one example of how the Fed searches for the optimal way to predict future inflation. All that matters for policy is finding the most accurate way to predict inflation, and they will use whatever definition of inflation is best suite for this job. There is evidence that core inflation is best and that's why it is used, but it is a statistical question and didn't have to come out that way (and the best measure of core inflation may not be simply stripping out food and energy - also, there are different measures of prices to choose from, e.g. the CPI and the PCE).

When it comes to setting policy, the Fed doesn't formally use a Taylor rule, though they certainly have Taylor rule estimates in the information they use when considering policy moves, instead they look at a variety of measures of inflation (both core and total), and they look at the rate of change in input prices such as wages and commodities (e.g. oil) as well. They then weight each of those pieces of information in some way (and hence construct an implicit index of all of this information), and then set the federal funds rate accordingly. While I have no way of knowing if the weights they use are optimal, this is exactly what the theoretical models say they should do. But the point is that it is some implicit combination of all of this information that matters for policy, and hence this core measure is very different from the core measure that is best at predicting future inflation alone.

The core inflation rate you see in the news, the CPI less food and energy, does do a fairly good job of representing the information the Fed uses to forecast future inflation, i.e. it is a measure of the trend rate of inflation (but not the best one), and it also does well at approximating the information the Fed will use to set policy, but the actual process it uses is more complicated than this and the Fed employs measures that are specialized for the job at hand.

Finally, there is also a question of what we mean by inflation conceptually. Does a change in relative prices, e.g. from a large increase in energy costs, that raises the cost of living substantially count as inflation, or do we require the changes to be common across all prices as would occur when the money supply is increased? Which is better for measuring the cost of living? Which is a better target for stabilizing the economy? The answers may not be the same.

Class Materials for Lecture 10

Chapter 20 The IS-LM Model

The IS curve

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

The LM Curve

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

Video:

not yet available

Class Material:

Additional Reading:

• A currency war has no winners - Joseph Stiglitz
• Negative real interest rates - Econbrowser
• Kohn Says QE2 Won’t Turn Economy Around - Real Time Economics
• The night they burned government bonds - Bluematter
• Will QEII Work? - The Bonddad Blog
• QE2 is risky and should be limited - Martin Feldstein
• Confusing messages from Fed’s many voices - FT.com
• How immigration can benefit native workers - D'Amuri and Peri
• Asian nations tighten ahead of Fed - FT.com

Application:

What the Fed did and why: supporting the recovery and sustaining price stability, by Ben S. Bernanke, Commentary, Washington Post: ...The Federal Reserve's objectives - its dual mandate, set by Congress - are to promote a high level of employment and low, stable inflation. Unfortunately, the job market remains quite weak; the national unemployment rate is nearly 10 percent, a large number of people can find only part-time work, and a substantial fraction of the unemployed have been out of work six months or longer. The heavy costs of unemployment include intense strains on family finances, more foreclosures and the loss of job skills.

Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run. ...

The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed. With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. ...

While they have been used successfully in the United States and elsewhere, purchases of longer-term securities are a less familiar monetary policy tool than cutting short-term interest rates. That is one reason the FOMC has been cautious, balancing the costs and benefits before acting. We will review the purchase program regularly to ensure it is working as intended and to assess whether adjustments are needed as economic conditions change.

Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.

Our earlier use of this policy approach had little effect on ... broad measures of the money supply... Nor did it result in higher inflation. We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time. The Fed is committed to both parts of its dual mandate and will take all measures necessary to keep inflation low and stable.

The Federal Reserve cannot solve all the economy's problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector. But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability. Steps taken this week should help us fulfill that obligation.

Midterm Solution

Midterm and Solution.