Economics 470/570 - Monetary Theory and Policy

Class Materials for Lecture 17

Brief Outline of Topics Covered in Lecture 17

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

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

• Anti-inflation policies
  
  • Traditional model
  • New classical model
    
  • New Keynesian model

• The role of credibility in fighting inflation
  
  • Show with AD-AS and Phillips curve diagrams
    

Materials from class:

Continue with materials posted for Lecture 16.

Video:

Additional Reading:

• Why Didn’t Canada’s Housing Market Go Bust? - FRB Cleveland
• Too risky to regulate? Not with proper verification - Ed Glaeser
• Senator Sanders Moves to Hold Up Bernanke Confirmation - NYTimes.com
• What Should Senators Ask Bernanke? Economists Weigh In - WSJ
• ‘Summit’ Or Stunt? - Market Talk
• What Went Wrong? - David Wessel - Big Think
• Uncertainty and the Fed - Freakonomics
• Economics-haters are going to hate this post - Environmental Economics
• Fed Debates New Role: Bubble Fighter - WSJ.com
• The Economics and Policy of Illegal Immigration - Gordon Hanson
• What Types of Employment Policies Should be Discussed at the Jobs Forum? - Mark Thoma

Application:

Bubbles and Policy, by Tim Duy: The Wall Street Journal carried a front page article today detailing changing views at the Federal Reserve regarding the policy treatment of emerging bubbles of speculative activity. Much of the ground has been well tread. Is monetary policy or regulatory policy the best mechanism to address bubbles? I tend to favor the latter category, should we have a regulatory environment that is not essentially captured by those policymakers are supposed to regulate. Interest rate policy is a rather blunt weapon that kills indiscriminately. For instance, I am sympathetic with the view that interest rates were not necessarily too low during the build up of the housing bubble. Indeed, relatively low rates of investment (equipment and software) growth suggests that real rates were actually too high. But capital flowed to housing instead of more productive investment activities because that was the path of least resistance. Policymakers could have chosen to put some grit on that path by, for example, aggressively evaluating lending standards with regards to products such as "Liar's Loans," etc., but chose to follow a hands off approach.

What caught my attention in the article was this passage:

Yet the question of whether and how to tackle bubbles before they burst is becoming a growing concern amid fears of new bubbles developing in commodities markets and in emerging economies. Gold prices are up more than 50% in a year's time. China's Shanghai Composite stock index is up more than 75% this year. Stocks in Brazil are up even more. Oil prices have rebounded. They remain far below last year's peaks but a return to those highs could fuel inflation in goods and services more directly than tech stocks or housing did.

I think it is important to recognize what bubbles should be the focus of Federal Reserve concerns. After all, the Fed is charged with maintaining price stability and maximum sustainable employment in the United States. Why should the Fed be concerned with housing prices in Hong Kong or stock prices in Brazil and China? Don't those bubbles fall under the responsible of foreign central banks? It seems clear that in such cases, the extent of the Fed's concerns should be limited to the regulatory arena. Are US based banks lending into those bubbles, thereby setting the stage for negative feedback loops? If so, raise capital requirements on that lending, tighten underwriting standards, etc. Just don't derail the US recovery by raising rates to pop a bubble in Brazil.

I will admit that oil prices can be a bit more tricky. The gains in oil prices seem silly given ongoing evidence that the world is awash in oil. From the WSJ:

Café owner Ken Kennard sees the glut in the global oil market as a potential environmental threat to this sleepy seaside tourist hub.

Mr. Kennard is worried about a fleet of oil tankers -- almost 40 in all, each packing hundreds of thousands of barrels of crude and oil-derived products -- that have anchored several miles off the coast of southeast England in recent months.

The heavy traffic stems from a near-record excess oil supply, a byproduct of the recession, that is prompting producers to stash oil offshore until they can find customers. The excess supply hasn't stopped oil prices from surging almost 80% this year and padding the pockets of big oil producers like Royal Dutch Shell PLC and the Organization of Petroleum Exporting Countries.

To be sure, some of the rise in the price of oil is attributable to the decline in the Dollar, a natural consequence of low US interest rates and an important channel for the transmission of monetary policy. But it is not clear that higher oil prices necessarily yield additional core inflationary pressure given the current institutional arrangements between labor and management. The recent experience has been that individuals were not able to convert high inflation expectations in 2008 into higher wages. Instead, the opposite occurred as consumption sunk and unemployment skyrocketed. All which means the Fed would need to think long and hard about leaning against the oil price increase if that entailed contractionary monetary policies; the costs are potentially high relative to the benefits. Here again, though, regulators need to be carefully evaluating the nature of lending into the oil space.

My views on this topic have shifted somewhat over the past two years. In early 2008, I was concerned that the Fed's rush to lower rates was contributing to destructive oil price bubble. But, in retrospect, nations that pegged to the Dollar and thus imported the Fed's easy policy were just as much, if not more, to blame, as those central banks failed to maintain policies appropriate for domestic conditions.

In short, the Fed does need to be aware of the full set of consequences of their policy stance. But bubbles abroad should not prevent the Fed from adopting the right policy stance for the US economy. Indeed, many of the bubbles discussed now clearly should not be the responsibility of the Fed.

Class Materials for Lecture 16

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:

• Why it is hard to imagine consumption reigniting - Richard Green
• Fed Begins Testing a Strategy to Exit a Securities Program - NYT
• Credit booms gone bust - Economists' Forum
• Why the Chinese don’t spend - James Surowiecki
• US personal bankruptcy reform exacerbated the housing crisis - voxeu.org

Application:

The CBO says the stimulus package worked. See " Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output as of September 2009, CBO."

Here's the key table from the report:

[click to enlarge]

Review Material for the Final

This is 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
Policy ineffectiveness proposition
Rational expectations
Price rigidity

Essay

Chapter 19 [cont.]

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. Is the economy self-correcting? What problems are encountered in the pursuit of activist policies?

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

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. Why might governments choose to monetize the debt?

22. 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.

23. 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.

24. 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

Brief Outline of Topics Covered in Lecture 15

Chapter 24 Money 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

Materials from class:

none this time

Video:

Application:

The Fed in a Corner, by Tim Duy: Over the years, I have warned a seemingly countless number of undergraduates that Fed's hold on monetary independence was tenuous at best. Independence is not guaranteed by the Constitution. Congress made the Fed, and Congress can unmake the Fed. The Fed could only maintain the privilege of independence if policymakers pursued policy paths that fostered maximum, sustainable growth. Deviating from such paths would have consequences.

The Fed is quickly learning the extent of those consequences, as Congress launches an assault on the Fed's independence.

Some find the loss of support for the Fed puzzling. Brad DeLong, for example, notes that Bernanke & Co. are doing exactly what they should have done:

First of all, from the day after the collapse of Lehman Brothers, the policies followed by the U.S. Treasury and the U.S. Federal Reserve and the U.S. administrations have been very helpful. They have been good ones. The alternative--standing back and watching the markets deal with the situation--would have gotten us a much higher unemployment rate than we have now. Credit easing by the Fed and support of the banking system by the Fed and the Treasury have significantly helped the economy: have kept things from getting much worse.

The Fed earns accolades from academics for its handling of the crisis, in particular since the Lehman failure. Fair enough; I have few quibbles with policy since last fall. But what about the years before Lehman, when the crisis was building? Where was the Fed then? Did they abdicate regulatory responsibility? How did banks develop such incredible exposure to off-balance sheet SIV's? How could the Fed ignore increasingly predatory lending in the mortgage market? What exactly was Timothy Geithner, then president of the all important New York Fed, regulating and supervising? Clearly not Citibank.

To be sure, there were plenty of other regulatory failures along the way, but the Fed - an independent Fed - should have been in a much better position to raise regulatory and supervisory roadblocks during the debt build-up compared to other, more politically susceptible agencies. The Fed's independence should have allowed it to be a leader, not a follower. Ideological objections to regulation, apparently, prevented the Fed from looking for problems in their own backyard. Rapid debt creation was justified as a response to asset appreciation, with little concern that the connection might just be a bit more self-reinforcing.

The resulting crisis left the Fed struggling to keep the ship afloat - and in that struggle the Fed stepped too deep into the realm of fiscal policy in an effort to keep the trains running on time. But that mission creep was simply incompatible with the Fed's desire for secrecy. This was all to predictable: Like it or not, you cannot commit literally billions of dollars of taxpayer money and in the process secretly funnel money through AIG to the investment banking community without expecting just a little blowback. The last I checked, this was still a democracy.

Worse now for the Fed is the impression that monetary authorities work first and foremost for Wall Street. Of course, Fed officials see this a bit differently - they see supporting Wall Street as their mechanism for supporting Main Street. Ultimately, without the former, the latter is locked out of capital markets, and economic chaos follows. The purpose of Wall Street is supposed to be to channel investment funds into Main Street. But most Americans no longer view Wall Street as ultimately working in their best interests - maybe correctly. This is the same Wall Street that aggressively pushed garbage loans onto the American people as policymakers praised the wonders of financial innovation. When did the purpose of finance evolve into simply a mechanism to enrich the relative few at the expense of many? And when did policymakers embrace this view? As Paul Krugman has noted, the Fed cannot envision a world not dominated by the magic of structured finance. Yet this is a world tht failed us to completely.

Ultimately, can you really blame Americans if they have lost their faith in the supposedly omnipotent Federal Reserve?

Now the Fed's relationship with the public is a mess. And I suspect it is going to get much worse. Free Exchange succinctly identifies the new challenge:

An independent central bank is crucial. Political control of monetary policy must inevitably lead to accelerating inflation and long-run economic instability. But at the moment, the American economy could use an increase in expected inflation. And a real threat to Fed independence would almost certainly deliver it, either because markets would anticipate increased political influence on monetary policy ever after, or because the Fed would seek to fend off pressure from Congress by easing further, which amounts to the same thing. But we don't actually want there to be a real threat to Fed independence, because that way uncontrolled inflation lies.

The Fed has made it clear that unemployment is expected to remain unacceptable high in the medium run while disinflationary pressures persist. Yet policymakers have also made it clear that they believe they have done all they can, or are willing, to do to combat unemployment. They equate credibility with maintaining a 1.7-2% inflation target. Couldn't credibility be consistent with a 4% inflation target? And wouldn't such a target be more appropriate in a zero interest rate world? But alas, challenging the Fed now with their independence at stake will only convince policymakers to dig in their heels more aggressively.

What if the only way to get the Fed to do the right thing is to strip them of their independence? It is a real possibility, although disastrous in the long-run. Yet look at the dithering from the Bank of Japan, still faced with a deflationary environment years and years after they pushed to zero rates:

It was no coincidence that the new government of Yukio Hatoyama chose the day when the Bank of Japan (BoJ) was holding a rate-setting meeting to make a lot of noise on the issue. Both the deputy prime minister and finance minister made concerned comments. Their unspoken message to the BoJ was clear: remove monetary-stimulus measures at your peril. At the end of its two-day meeting, the BoJ left its policy rate unchanged at 0.1%, and continued to use other measures, such as buying government bonds, that it believes make monetary policy “extremely accommodative.”

But the BoJ does not give the impression it is particularly concerned about prices. It believes there are not yet clear signals of a deflationary mindset in corporations or the public at large, and that a recovery in private demand will eventually pull the economy out of its slump.

Good Lord, we have been talking about pulling Japan out of its slump for TWO DECADES! Fear of inflation combined with a perception that acquiescing to a higher inflation target would be akin to losing monetary independence has kept BoJ policy constrained for years, ensuring the citizens of Japan ongoing pain. Is the Fed headed to the same place? Maybe.

I don't think the Fed can regain the trust of the public while at the same time protecting the secrecy of their actions to save Wall Street (moreover, it is not clear that such secrecy is now needed in any event). The relationship between policymakers and financiers is now seen as far too cozy from the perspective of the public. I think the Fed needs to make clear that they work for the people, not for Wall Street. A strong statement by Federal Reserve Chairman Ben Bernanke that a firm that is too big too fail is simply too big - that we should no longer tolerate the expansion of financial firms to the point that they pose systemic risk - would be a good start. Simply put, Bernanke's choice set is dwindling - either risk losing independence, or step up to the regulatory and policy plate like you intend to hit one out of the park. If Wall Street is no longer working for Main Street, it is time to side with Main Street.

Class Materials for Lecture 14

Brief Outline of Topics Covered in Lecture 14

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:

• A Case in Antiquities for ‘Finders Keepers’ - NYTimes.com
• Obamas Economic Policies are Working (debate) - intelligencesquaredus.org
• Promise in a ‘Cash for Caulkers’ Program to Weatherize Homes - NYTimes.com
• Banking Fix Made Easy With Six Simple Steps - Roger Lowenstein
• Inventing a Better Patent System - NYTimes.com
• Uncertainty and the tale of two depressions - voxeu.org
• At Failed Banks, Post-Mortems Disclose Excessive, Yet Obvious, Risk - NYT
• Explaining Time, the Universe, and All That - Discover
• Fiscal Expansion That Is Deficit Neutral in the Long Run - Brad DeLong
• The IMF Needs Fresh Thinking on Capital Controls - Dani Rodrik
• Taming the Stock Option Game - Lucian Bebchuk and Jesse Fried

Application:

This is something I talked about in a class last week:

The effectiveness of fiscal and monetary stimulus in depressions, by Miguel Almunia Agustín S. Bénétrix Barry Eichengreen Kevin H. O’Rourke Gisela Rua, Vox EU: The debate over the effectiveness of stimulus rages on (Barro and Redlick 2009). Fewer than two years of data – that being the amount of time since monetary and fiscal measures to counter the crisis were put in place – are not enough to pin down the effects. And different theoretical models, for better or worse, predict different results. Strongly held priors rule the roost.

There is, however, one important source of information on the effectiveness of monetary and fiscal stimulus in an environment of near-zero interest rates, dysfunctional banking systems and heightened risk aversion that has not been fully exploited: the 1930s. This column – based on a paper presented at the 50th Economic Policy Panel Meeting held in Tilburg on 23-24 October 2009 – draws out some of the lessons for today’s crisis (Almunia et al. 2009).

Parallels: the Great Depression and the Great Recession

In previous columns, two of us documented the strong parallels between the early stages of the Great Depression and the early stages of our Great Recession. The causes of the two episodes were quite similar. In the earlier episode they included an unsustainable real estate boom (centred in Florida), lax supervision and regulation, and global imbalances (known then as “the transfer problem”). Similar circumstances suggest similar effects of policy, whether positive, negative or none.

The problem is that the policy response then was limited. The Keynesian argument for expansionary fiscal policy – whether right or wrong – was not known in this pre-Keynesian era. Hence there was relatively little variation in fiscal stance, with conservative policies being the default option. The aggressive use of discretionary monetary policy was also relatively unusual, as central banks were wedded to gold-standard ideology.

But there were exceptions. Japan’s aggressive use of monetary policy under Takahashi was one, Italy’s large budget deficits under Mussolini another. And there were good – exogenous – reasons for this variation. Fiscal impulses were generally governed by forces other than immediate economic conditions; Italy’s war in present-day Ethiopia, Hitler’s rearmament, the approach of World War II. Who responded to the crisis with monetary stimulus depended heavily on prior monetary experience; counties that had suffered high inflation in the 1920s tended to be reluctant to abandon the gold standard in the 1930s.

New research

Cross-country comparisons can thus help us untie the Gordian Knot and move the debate from the realm of ideology to that of evidence. Our project therefore focuses on assembling annual data on growth, budgets and central bank policy rates, mainly from League of Nations sources, for 27 countries covering the period 1925-39.

This leaves the question of what model or empirical technique to apply. Rather than prejudging the answer, we employ a battery of empirical methods. ...

The details of the results differ, but the overall conclusions do not. They show that where fiscal policy was tried, it was effective.

Our estimates of its short-run effects are at the upper end of those estimated recently with modern data; the multiplier is as large as 2 in the first year, before declining significantly in subsequent years.... This is, in fact, what one should expect if one believes that the effectiveness of fiscal policy is greatest when interest rates are at the zero bound, leading to little crowding out of private spending. It is what one should expect when households are credit constrained by a dysfunctional banking system. Given similar circumstances in 2008, this underscores the advantages of using 1930s data as a source of evidence on the effects of current policy. ...

Monetary policy in the 1930s was not powerless

The results for monetary policy are less robust but point in the same direction. A positive shock to the central bank discount rate leads to a fall in GDP...

This result is notable, given the presumption, widespread in the literature, that monetary policy is ineffective in near-zero-interest-rate (liquidity trap) conditions. On the contrary, in the 1930s it appears that accommodating monetary policy helped, by transforming deflationary expectations (Temin and Wigmore 1990) and by helping to mend broken banking systems (Bernanke and James 1991). Given the prevalence of both problems circa 2008, we suspect that the results carry over.

For others with different priors, these results may sit less easily. But the time for priors is over. Policy should rest on an evidentiary basis. The evidence we have marshalled so far speaks clearly. ...

• A Case in Antiquities for ‘Finders Keepers’ - NYTimes.com
• Obamas Economic Policies are Working (debate) - intelligencesquaredus.org
• Promise in a ‘Cash for Caulkers’ Program to Weatherize Homes - NYTimes.com
• Banking Fix Made Easy With Six Simple Steps - Roger Lowenstein
• Inventing a Better Patent System - NYTimes.com
• Uncertainty and the tale of two depressions - voxeu.org
• At Failed Banks, Post-Mortems Disclose Excessive, Yet Obvious, Risk - NYT
• Explaining Time, the Universe, and All That - Discover
• Fiscal Expansion That Is Deficit Neutral in the Long Run - Brad DeLong
• The IMF Needs Fresh Thinking on Capital Controls - Dani Rodrik
• Taming the Stock Option Game - Lucian Bebchuk and Jesse Fried

Homework #6

Economics 470
Fall 2009
Homework 6
Due Tuesday, November 24

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

Brief Outline of Topics Covered in Lecture 13

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

• 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

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

Video

Materials from class:

Additional Reading

• Audit Faults New York Fed in A.I.G. Bailout - NYTimes.com
• Assessing the Impact of Government Policy - Econbrowser
• Credit Constraints and the Persistence of Unemployment - NEP-DGE Blog
• Post-Crisis: What Should Be the Goal of a Fiscal Exit Strategy? - iMFdirect
• "Asset Price Bubbles and Monetary policy" - FRB Chicago
• How Washington Can Create Jobs - Alan Blinder
• At Swoopo.com, a Price for the Thrill of the Auction - NYTimes.com
• Ben Bernanke’s Outlook for the Economy - Mark Thoma

Application:

Ben Bernanke’s Outlook for the Economy, by Mark Thoma, MoneyWatch: A few quick reactions to Ben Bernanke’s speech today where he talks about something of concern recently–namely, how the Fed will view changes in the value of the dollar. If the dollar begins to fall, that will increase the price of imported goods and materials used in production and that, in turn, adds to domestic inflationary pressure. To support the dollar and lower the inflation pressure, the Fed would have to raise interest rates, but that would endanger the recovery of domestic output and employment by raising borrowing costs, and it would also make U.S. exports more expensive to foreign buyers.

So, if the dollar starts falling, will the Fed raise interest rates to head off the inflationary pressure, or will it maintain low interest rates in an attempt to stimulate the economy? Bernanke says they will certainly keep an eye on the dollar, but it’s only one part of a larger picture:

We are attentive to the implications of changes in the value of the dollar and will continue to formulate policy to guard against risks to our dual mandate to foster both maximum employment and price stability. Our commitment to our dual objectives, together with the underlying strengths of the U.S. economy, will help ensure that the dollar is strong and a source of global financial stability.

So what will the Fed do? Bernanke made it clear that while he sees some improvement, we are very far from the “all clear” sign for the economy:

On the one hand, those who see further weakness or even a relapse into recession next year point out that some of the sources of the recent pickup–including a reduced pace of inventory liquidation and limited-time policies such as the “cash for clunkers” program–are likely to provide only temporary support to the economy. On the other hand, those who are more optimistic point to indications of more fundamental improvements, including strengthening consumer spending outside of autos, a nascent recovery in home construction, continued stabilization in financial conditions, and stronger growth abroad.

My own view is that the recent pickup reflects more than purely temporary factors and that continued growth next year is likely. However, some important headwinds–in particular, constrained bank lending and a weak job market–likely will prevent the expansion from being as robust as we would hope.

He also made it clear that inflation is not much of a worry right now:

The outlook for inflation is also subject to a number of crosscurrents. Many factors affect inflation, including slack in resource utilization, inflation expectations, exchange rates, and the prices of oil and other commodities. Although resource slack cannot be measured precisely, it certainly is high, and it is showing through to underlying wage and price trends. Longer-run inflation expectations are stable, having responded relatively little either to downward or upward pressures on inflation; expectations can be early warnings of actual inflation, however, and must be monitored carefully. Commodities prices have risen lately, likely reflecting the pickup in global economic activity, especially in resource-intensive emerging market economies, and the recent depreciation of the dollar. On net, notwithstanding significant crosscurrents, inflation seems likely to remain subdued for some time.

Putting those two things together, fear that the economy will not recover as robustly as we’d like, plus the belief that inflation pressures are not a worry right now, leads to the following policy:

The Federal Open Market Committee continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

I agree (very much) that inflation is not a worry right now, and that the Fed should be primarily concerned with output and employment at this point. Today’s remarks were intended to reassure markets (and foreigners holding our debt) that the dollar is on the Fed’s radar, and that it won’t allow the dollar to go into free fall. But practically, today’s remarks tell us that the Fed expects to maintain low interest rates for the foreseeable future.

(For a more wonkish take on current policy, see Tim Duy’s latest Fed Watch.)

Class Materials for Lecture 12

Brief Outline of Topics Covered in Lecture 12

Chapter 20 The IS-LM Model [cont.]

• The liquidity trap

Equilibrium

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

Video:

Additional Reading

• A comprehensive solution to combustible markets - Barney Frank
• Talking about Tomorrow’s Monetary Policy Today - FRBSF Economic Letter
• Bernanke Learns Flexibility in the Debate Over Fed’s Role - NYTimes.com
• Banks bill seeks to strip Fed of powers - FT.com
• Will rising oil prices derail the recovery? - Econbrowser
• Politicizing the Fed? - washingtonpost.com
• Yellen Is More Worried About Disinflation - Real Time Economics

Application:

Depression multipliers, by Paul Krugman: Barry Eichengreen and Kevin O’Rourke have lately been scoring a series of research coups, based on the combination of historical perspective and a global view. Most famously, they showed that on a global basis the first year of the current crisis was every bit as severe as the first year of the Great Depression.

Now they and collaborators have a new piece on policy effects, especially fiscal multipliers.

The background here is that there are two problems with estimating multipliers relevant to our current situation. First, you need to look at what happens under liquidity-trap conditions — and except in Japan,these haven’t prevailed anywhere since the 1930s. The second is that in the United States, fiscal policy was never forceful enough to provide a useful natural experiment. We didn’t have a really big fiscal expansion until World War II; and WWII isn’t a good experiment because the surge in defense spending was accompanied by government policies that suppressed private demand, such as rationing and restrictions on investment.*

What E&R do here is use a broad international cross-section to overcome this problem. This works because a number of countries had major military buildups during the 1930s — fiscal expansions that can be regarded as exogenous to the economic situation, since they were

driven above all by Hitler’’s rearmament programmes and other nations’’ efforts to match the Nazis in this sphere, and by one-off events like Italy’’s war in Abyssinia.

What do E&R find? Initial fiscal multipliers of 2 or more, although they shrink over time. Yes, fiscal expansion is expansionary.

* I really, really don’t understand why this point has been so hard to get across.

Homework #5

Economics 470
Fall 2009
Homework 5
Due Tuesday, November 17

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.

Midterm Answers

Here is a copy of midterm.

Here is the key:

Class Materials for Lecture 11

Brief Outline of Topics Covered in Lecture 11

Chapter 20 The IS-LM Model [cont.]

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

Equilibrium

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

Video:

Class Material:

See the class materials for the lecture before this one

Additional Reading:

• Jobless Recovery - NYTimes.com
• Offshoring and composition of home employment - voxeu.org
• The Recession’s Over, but Not the Layoffs - NYTimes.com
• In Health Care Bills, a Catalyst for Salaried Doctors - Robert Frank
• It Wasn't Lax Lending Standards. Really. - The New Republic
• The economics of open-air markets - voxeu.org
• Economists Seek to Cure a Defect in National Data - NYTimes.com
• Dogs verus SUVs - Salon.com
• What is systemic risk, anyway? - macroblog

Application:

The author of your textbook, along with a co-author, has an editorial in today's WSJ (he actually has two, the other is in teh Fiancial Times: Not all bubbles present a risk to the economy, by Frederic Mishkin, summary here):

The Fed Is Already Transparent, by Anil K. Kashyap and Frederic S. Mishkin, Commentary, WSJ: Under the banner of increasing Federal Reserve transparency, Congressman Ron Paul has sponsored a bill that would subject the Fed's monetary policies to an audit by the Government Accountability Office (GAO). The bill is a veiled attempt to undermine the Fed's independence. If it passes, it will cripple policy making—particularly when it comes to inflation.

It is completely appropriate to hold the Fed accountable for its decisions. But the Paul bill, H.R. 1207, will only produce redundancies: Congress already has multiple ways of finding out what the Fed is doing and why.

The Fed produces a report and testifies twice a year before Congress about its monetary policy actions. During this testimony, the Fed is forced to explain what it has done, and elected officials question the Fed about its choices. In addition, the Fed makes the minutes from its monetary policy meetings available to the public, and Fed officials routinely give speeches explaining their approach.

What's more, it is highly doubtful that the GAO has the technical competence to evaluate monetary policy. If it did try to conduct these audits, at best it would merely rehash known information. At worst, the GAO would generate confusion by offering its own analysis.

Economic theory and massive amounts of empirical evidence make a strong case for maintaining the Fed's independence. When central banks are subjected to political pressure, authorities often pursue excessively expansionary monetary policy in order to lower unemployment in the short run. This produces higher inflation and higher interest rates without lowering unemployment in the long term. This has happened over and over again in the past, not only in the United States but in many other countries throughout the world.

The Fed's independence is critical to its credibility. During the financial crisis, this credibility allowed the Fed to take extraordinary action to prevent a possible depression without triggering inflation. But eventually the Fed will have to scale back its unprecedented monetary accommodation. When it does move to tighten monetary conditions, it must be allowed to do so without political interference.

Weakening the Fed's independence now might raise the risk of inflation, which would cause borrowing costs to rise and would lower prospects for a strong economic recovery. For these reasons, we joined over 400 prominent economists in July when we signed a petition opposing the type of incursion on the Federal Reserve that Mr. Paul is proposing.

Fortunately, Congress is considering an amendment to the bill that would prevent the negative consequences of the original Paul legislation. This amendment, put forward by Rep. Mel Watt (D., N.C.) would change the focus of the bill by instructing the GAO to audit the new lending facilities at the Federal Reserve that were authorized under the 13(3) "unusual and exigent circumstances" clause of the Federal Reserve Act. The 13(3) lending authority, which had not been used by the Fed since the Great Depression, was the basis for many of the most controversial decisions made during the crisis, including the rescue of AIG and the establishment of new lending facilities.

This audit would involve oversight of the operational integrity of these facilities' accounting, internal controls, and protection against losses. It would also disclose the borrowers from these facilities one year after the facilities are closed. The audit would produce new, important information that is not otherwise available and would play to the strengths of the GAO. And the amendment would exempt the Fed's normal monetary policy actions from the audit.

We strongly support an amendment of this type because it will increase the Fed's accountability without compromising its monetary independence. We also believe that the lag in disclosing the names of borrowers would enable Congress to have appropriate oversight over these facilities without compromising their effectiveness. Earlier disclosure would diminish the efficacy of these facilities because of the so-called stigma problem: If borrowing from emergency lending facilities is immediately made public, the markets would know that the borrowers might have financial difficulties, which would make it harder for the borrowers to operate.

No one can be fully comfortable with all the unprecedented actions that the Fed has taken to limit the damage from the financial crisis. We appreciate the frustration of the public and members of Congress who want a better understanding of what has happened. Forming a committee of experts to write a report on the crisis might help reassure the public and provide some lessons for crisis management in the future. But the Paul bill, as originally written, won't help with these goals and will only stifle the recovery.

Class Materials for Lecture 10

Brief Outline of Topics Covered in Lecture 10

Chapter 19 Money Demand [cont.]

• 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

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:

Class Material:

Additional Reading:

• The trade collapse: The role of product quality - voxeu.org
• The Amazon Wal-Mart price war - The New Yorker
• What The Woman Lived - Economic Principals
• Naming Systemically Dangerous Firms - The Baseline Scenario
• P vs. NP - MIT News
• Employment under Differing Econometric Specifications - Econbrowser
• Inflation Expectations and the Risk of Deflation - FRBSF Economic Letter

Application:

There's a chance, as always, that I'll talk about something else, but this is still worth reading:

Why do central banks have assets?, by Nick Rowe: If you look at the balance sheet of a central bank, you will see it has liabilities (mostly currency) and assets (normally mostly government bonds/bills). Why do central banks have assets? Do they need them?

The wrong answer is that central banks need assets to "back" the value of the currency, and that paper currency would be worthless otherwise. The right answer is: since the government gets all the profits from a central bank anyway, there's no point in giving the government the assets; that owning assets lets the bank reverse course and reduce the money supply if it ever needs to; and it stops the accountants freaking out.

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.

Class Materials for Lecture 2

Brief Outline of Topics Covered in Lecture 2

Chapter 1 Why Study Money, Banking, and Financial Markets? [continued]

Function of Financial Intermediaries

Continue Example

Chapter 3 What is Money?

Meaning of Money
Functions of Money

Medium of Exchange
Unit of Account
Store of Value

Evolution of the Payments System

Commodity Money
Partially backed paper money
Full backed paper money
Fiat Money

Measuring Money

The Federal Reserve’s Monetary Aggregates

How Reliable Are the Money Data?

Chapter 4 Understanding Interest Rates [pages 84-85]

The Distinction between Real and Nominal Interest Rates

Nominal interest rates
Ex-ante real rates
Ex-post real rates

Materials from class:

Video:

Additional Reading:

• The Stone Money of Yap
• Technology and Class Attendance (a worry of mine...)
• Benjamin Franklin and the Birth of a Paper Money Economy
• FAQs about Interest on Reserves - FRB New York
• The true fiscal cost of stimulus - Paul Krugman
• America has passed on the baton- Jeff Sachs
• The Newest Global Religion - Bill easterly
• Bill Would Make Ratings Agencies Share Liability - NYTimes.com
• I.M.F. Calls for Overhaul of Financial System - NYTimes.com
• World Bank to buy distressed assets - FT Alphaville
• PPIP Starts with Modest $1.13 Billion Investment - WSJ.com
• Journalism and Economics - Nick Rowe
• Determining the size of the fiscal multiplier - voxeu.org
• E.P.A. Moves to Curtail Greenhouse Gas Emissions - NYTimes.com
• Does unconventional mon. policy solve the zero bound problem? - Paul Krugman
• Updated Long-Term Fiscal Deficit and Debt Projections — CBPP
• G.D.P. Shrank Less Than Expected in Quarter - NYTimes.com
• Q&A: Shiller Sees 5 Years of Stagnant Home Prices - Real Time Economics

Application:

Does unconventional monetary policy solve the zero bound problem?, by Paul Krugman: Some comments on my post on the true cost of fiscal stimulus argue that the zero lower bound aka liquidity trap isn’t really binding, because the Fed is using other measures to expand the economy. A few commenters imply that I haven’t been paying attention.

Well, yes I’m aware that BB is doing a bunch of unconventional stuff. But the available — albeit thin — evidence is that it takes a huge expansion of the Fed’s balance sheet to accomplish as much as would be achieved by a quite modest cut in the Fed funds rate. And the Fed isn’t willing to expand its balance sheet to the $10 trillion or so it would take to be as expansionary as it “should” be given, say, a Taylor rule.

Which means that the zero bound is still binding, which means that right now we’re very much still in liquidity trap territory.

Class Materials for Lecture 1

Brief Outline of Topics Covered in Lecture 1

Chapter 1 Why Study Money, Banking, and Financial Markets?

Why Study Money and Monetary Policy?

Money and Business Cycles
Money and Inflation
Money and Interest Rates
Conduct of Monetary Policy
Fiscal Policy and Monetary Policy

Why Study Banking and Financial Institutions?

What Defines Banks and Financial Institutions?
What is Financial Intermediation?
Direct versus Indirect Finance
Why is Financial Intermediation Important?

Why Study Financial Markets?

Bond Market
Stock Market
Foreign Exchange Market

Chapter 2 An Overview of the Financial System (pgs 25-27, 39-42)

Functions of Financial Markets

Direct versus Indirect Finance

Structure of Financial Markets

Function of Financial Intermediaries

Example

Chapter 3 What is Money?

Meaning of Money
Functions of Money

Medium of Exchange
Unit of Account
Store of Value

Video:

Materials from class:

The financial crisis—and ensuing recession—has helped
turn  economics bloggers like (clockwise from top left)
Greg Mankiw, Paul Krugman, Alex Tabarrok and Mark Thoma
into Internet celebrities (WSJ)

Links:

• Predicting Crises, Part II - FRBSF Economic Letter
• Lessons from the 1970s for Fed Policy Today - David Papell
• The Fed draining reserves? - News N Economics
• Is Mankiw being completely above board? - Environmental Economics
• Is Krugman being completely above board? - Environmental Economics
• In Liquid and Air, Scientists Find Order Among the Chaos - NYTimes.com

Application: This is something the Oregonian asked me to do around a year ago:

Mark Thoma, Guest opinion, Oregonian, Sept. 19, 2008: Many people associate the onset of the Great Depression with the stock market crash in October 1929. But a more important cause was a series of banking panics in the years prior to the Great Depression, and the particularly severe banking collapse from 1930-1933.

Syllabus for Fall 2009

Course: Economics 470/570 Monetary Theory and Policy
Professor: Mark Thoma
Office/Hours: PLC 471 on T/Th 11:30 a.m.-12:30 p.m.
Phone/Email: (541) 346-4673, [email protected]
Web Page: http://darkwing.uoregon.edu/~mthoma/

Text: Frederic S. Mishkin, The Economics of Money, Banking, and Financial Markets, 9th edition (Pearson).

Prerequisites: Economics 313 or the equivalent.

GTF/Office/Hours: Mark Ryan, PLC 405, W/Th 3-4 p.m., [email protected]

Tests: There will be a midterm and a final. The midterm will be given on Thursday, November 5^th, and the final will be given on Tuesday, December 8^th from 8:00 a.m. – 10:00 a.m. 

Homework: Problem sets will be assigned periodically. These are graded, and exam questions will be based, in part, upon the problem sets.

Grading: The midterm is worth 35%, the homework counts as 20%, and the final is worth 45%.  Grades will be assigned according to your relative standing in the class.

Course Outline:

Introduction	Mishkin Text
Introduction	Ch. 1, 2
The Role of Money in the Macroeconomy	Ch. 3, Ch. 4 pgs. tba
Central Banking and the Conduct of Monetary Policy
Structure of Central Banks and the Federal Reserve System	Ch. 12
Multiple Deposit Creation and the Money Supply Process	Ch. 13
Determinants of the Money Supply	Ch. 14
Tools of Monetary Policy	Ch. 15
Monetary Theory
The Demand for Money	Ch. 19
The Keynesian Framework	Ch. 20
Monetary and Fiscal Policy	Ch. 21
The AS-AD Model	Ch. 22
Money and Inflation	Ch. 24
Rational Expectations: Theory and Policy Implications	Ch. 25

Course materials for Fall 2008

Link to course materials for Fall 2008.

(Links to other quarters are on the sidebar.)