Review Material for the Final Economics 470/570 Fall 2011
There are three sets of questions for the final, those for Midterms 1 and 2, and the definitions/questions over the material since the second midterm that are given below.
Natural rate of output and employment Inflation, output, and interest rate targets Taylor rule Activists and non-activists Data, recognition, legislative, implementation, and effectiveness lags Federal reserve credibility
Questions:
1. Do monetary and fiscal policy become more or less effective when consumption, investment, or net exports become more responsive to changes in the interest rate? Explain.
2. Do monetary and fiscal policy become more or less effective when the MPC increases? Explain.
3. Do monetary and fiscal policy become more or less effective when the Fed raises interest rates more aggressively in response to changes in output? Explain.
4. Is the economy self-correcting? Explain.
5. Explain the activist and non-activist positions on the use of government policy to stabilize macroeconomic variables such as real output. What problems are encountered in the pursuit of activist policies?
6. Why does the SRAS slope upward? What causes the SRAS to shift?
7. Why is the LRAS vertical? What causes the LRAS to shift?
8. Show graphically that monetary and fiscal policy have no long-run effect on output when prices and wages are allowed to vary.
9. Show graphically how inflation and output adjust in the short-run and long-run in response to an improvement in technology.
10. Why does the Federal Reserve put so much emphasis on its credibility?
Review Material for Midterm 2 Economics 470/570 Fall 2011
These are review questions for the midterm exam which will be on Tuesday, November 15.
Definitions
Quantity equation Velocity of money Equation of exchange Aggregate demand or expenditures Expenditure multiplier AE curve MP curve Inflation target Interest rate target Output target Policy effectiveness Crowding out Debt monetization Inflation Government budget constraint
Questions
1. (a) Explain why the demand curve for reserves slopes downward. (b) Explain the shape of the supply curve for reserves.
2. 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.
3. Describe the three traditional tools available to the Fed for controlling the money supply.
4. 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.
5. Explain the quantity theory of money. What assumptions are imposed to arrive at a theoretical statement? Explain the Cambridge approach and illustrate that it leads to the same result as the quantity theory.
6. What is the money demand function in the classical model?
7. 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?
8. Show the money demand curve graphically and explain why it slopes downward. Show how the money demand curve shifts when income increases.
9. 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?
10. What did Tobin add to Keynes theory of the speculative demand for money? Why was this development important?
11. Explain Friedman's Modern Quantity Theory of the Demand for Money.
12. Can budget deficits lead to inflation? Explain using the government budget constraint.
13. Derive the AE curve.
14. What makes the AE curve flatter or steeper?
15. What causes the AE curve to shift?
16. What is the MP curve?
17. Explain the difference between the MP curve used in the book and the MP curve used in class.
18. Show and explain how the MP curve shifts when there is a change in the inflation rate.
19. Using the MP curve from class, derive the dynamic AD curve.
20. Show graphically how the AD curve shifts when there is a change in government spending or taxes. In general, what causes the AD curve to shift?
What Moves the Interest Rate Term Structure?, by Michael Bauer, Economic Letter, FRBSF: To understand the effects of news on bond markets, it is instructive to look beyond individual maturities and consider the entire term structure of interest rates. For example, unexpected changes in monthly nonfarm payroll employment numbers cause large movements at short and medium maturities, but do not affect long-term interest rates. Inflation news affects the long end of the term structure. Monetary policy actions vary in their effects on interest rates, but cause volatility at all maturities, including distant forward rates.
Daily changes in various interest rates are a staple of the financial news. But what causes these constant up-and-down movements? The underlying determinants are factors such as prospects for economic growth, expectations regarding inflation and monetary policy, and compensation for risk. Interest rates change as market participants receive new information about these factors. Often, various interest rates move together in the same direction.
However, there is more to interest rate changes than direction and magnitude. Bonds that mature at different time horizons do not move in lockstep. Much can be learned by looking at changes in the term structure of interest rates, that is, the entire range of rates from short maturities to long. Sometimes short-term interest rates move strongly and the long end of the term structure barely shifts. At other times, the short end remains anchored and the action is only in medium- and long-term rates. Identifying changes in interest rates across the maturity spectrum can be useful when assessing the impact of news on market expectations about the macroeconomy and future monetary policy. This Economic Letter looks at how different types of news affect interest rates across maturities.
Shifts in the term structure of interest rates
Yields on U.S. Treasury securities typically receive the most attention in reporting on the fixed income markets. Treasury security maturities range from less than a month to about 30 years. Gürkaynak, Sack, and Wright (2007) have constructed a useful data set of Treasury security yields and forward rates based on the prices of these securities. The data set is updated every day and publicly available at http://www.federalreserve.gov/econresdata/researchdata.htm.
To get a better picture of the effects of news on interest rates at different time horizons, I look at forward interest rates. Forward rates are rates contracted today for a loan made or security issued at a specified future date. A forward rate with, say, two years maturity is the interest rate that would be contracted for today on an overnight loan to be extended in two years. Conceptually, the forward interest rate is determined by expectations about the real short-term interest rate and the rate of inflation two years in the future. The rate also includes compensation for the interest rate risk of a two-year commitment. Changes in forward rates with different maturities reflect expectations of inflation and monetary policy at specific time horizons.
Figure 1 Interest rate changes on July 8, 2011
For example, consider the employment report released on July 8, 2011, in which the U.S. Bureau of Labor Statistics (BLS) reported that total nonfarm payroll employment increased by 18,000 in June. This fell well short of the consensus forecast for a 105,000 increase in payroll positions and was interpreted as bad news regarding the pace of economic recovery. Figure 1 shows the daily changes between July 7 and July 8, 2011, in hundredths of a percentage point for one- to ten-year Treasury yields and forward rates one to ten years ahead. All yields decreased, but by different magnitudes.
To get a better idea of the interest rate movements across horizons, I consider forward rates instead of yields. A forward rate is about one specific future point in time whereas yields are averages of forward rates. Thus forward rates offer clearer information about different horizons. On July 8, following the BLS employment report, the largest movements occurred in forward rates two to four years ahead. Changes at the longer end of the term structure eight to ten years out were much smaller. To the extent that these yield changes reflect shifting expectations for future short-term interest rates, the June employment report caused market participants to lower their anticipated path for the Federal Reserve’s policy rate, the federal funds rate, most dramatically at the two- to four-year horizon.
Macro surprises and the response of the term structure
Figure 2 Responses of forward rates to surprises
A. Payroll News
B. Core CPI News
The employment report example demonstrates a typical pattern. Interest rates respond to macroeconomic surprises in a pro-cyclical fashion. That is, yields fall in response to weaker-than-expected data and rise in response to stronger-than-expected data. Several empirical studies have documented this pattern. Balduzzi, Elton, and Green (2001) studied the response of some specific Treasury yields to macroeconomic announcements using a now standard event study methodology. The authors constructed a measure of surprise based on the difference between actual data and the median forecast in surveys prior to the data release, standardized to be comparable across different releases. They then performed a statistical exercise to measure the responses of Treasury yields to the macroeconomic surprises. Studies of this sort typically find that short-term yields respond little, but long-term yields react strongly to macroeconomic data surprises.
To go beyond individual yields, I estimate the responses across the entire term structure, and capture changes in all interest rates. Most of the variation in interest rates is captured by just a few underlying statistical factors. Based on this idea, it is possible to build a model that calculates the responses to economic data releases of Treasury security yields and forward rates across the entire term structure (see Bauer 2011).
Figure 2 shows the response of the forward rate curve to surprises in payroll employment and to the core consumer price index (CPI), which excludes food and energy. The dashed lines indicate the model’s predictions with 95% confidence. Forward rates at short and medium horizons show large and significant responses to surprises in nonfarm payrolls. The strongest response, around 0.07 percentage point, occurs at a maturity of about two years. Notably, far-ahead forward rates at horizons longer than six years do not significantly respond to the employment news. On the other hand, responses to core CPI inflation surprises are smaller in magnitude, but extend to the long end of the maturity spectrum. Distant forward rates show a small but statistically significant increase of about 0.015 percentage point to a higher-than-expected core CPI.
Thus, this model suggests an important difference between the effects of employment news and inflation news on interest rates. While employment news causes large responses, only inflation news affects the long end of the term structure (see Bauer 2011). This result contrasts with the findings of other studies regarding the long forward rate response to economic news (see Gürkaynak, Sack, and Swanson 2005).
Monetary policy actions
Monetary policy actions, such as changes in the federal funds target, releases of Federal Open Market Committee (FOMC) statements, or speeches by committee participants, often contain new information relevant to financial markets. Importantly, while the Fed has direct control only over the federal funds rate, it can also affect interest rates at other maturities by changing expectations of future monetary policy. How does monetary policy affect the term structure? In what way does it affect longer-term interest rates, which are crucial in determining lending costs and mortgage rates, and strongly influence economic behavior? Looking at the entire term structure of forward rates reveals how much news about monetary policy changes perceptions of economic fundamentals and affects rates at different horizons. Specifically, changes in the term structure show whether policy actions directly affect distant forward rates or whether the effects die after medium horizons.
An important difference exists between macroeconomic news and monetary policy news. We can quantify economic surprises, but we do not have a measure that satisfactorily captures all aspects of policy surprises. The language of FOMC statements and speeches cannot easily be quantified. To capture the surprise component, researchers have focused on how policy actions affect financial markets (see Kuttner 2001). Thus, to assess the effects of policy actions, I employ the same model-based methodology I used with employment and inflation news, examining changes across the entire term structure of interest rates as policy surprises were made public.
Figure 3 Effects of monetary policy actions on forward rates
Figure 3 shows the effects on forward rates of three Fed moves in 2007 to lower the federal funds target: a half percentage point cut on September 18, a quarter percentage point cut on October 31, and another quarter percentage point cut on December 11. These three easing actions had very different effects on the term structure. In September, the size of the cut surprised market participants. Short-term rates fell, but longer forward rates actually increased, which may have reflected an upward revision in expectations about economic growth. In October, forward rates at short and medium horizons increased on the day of the meeting, probably because markets had expected a larger federal funds rate move or a change in the language of the Fed’s policy statement. Thus, monetary policy was viewed as tighter than previously anticipated. Markets had anticipated the Fed’s December cut, so the short end of the term structure did not move much. But medium and longer-term forward rates fell significantly. Changing statement language apparently led market participants to expect much easier monetary policy over the medium and long horizons.
This variability of term structure shifts is typical of the effects of monetary policy on interest rates. This reflects the fact that policy actions are inherently multidimensional. Markets must consider both a federal funds rate decision or other policy action and an FOMC statement whose language may have changed from previous statements. The effects of policy actions and statements vary based on market expectations. The strongest effects occur when market participants are surprised. This makes monetary policy actions complex objects that affect the term structure of interest rates in highly variable ways. The complexity of monetary policy would also be apparent from the movements of inflation-adjusted interest rates, inflation expectations, and other asset prices.
Figure 4 Forward rate variability
Are there systematic effects of monetary policy on the term structure? Considering policy-driven interest volatility is helpful in answering this question. Figure 4 compares the forward rate volatilities on days of FOMC statements with the volatilities on days without such statements. Days on which the Fed released statements about monetary policy show higher volatilities than other days. Evidently, monetary policy is a key driver of interest rate movements. While most action is in rates at medium maturities of two to three years, policy actions also cause significant volatility in distant forward rates. Of course, this does not tell us whether long rates move in the same direction as shorter-term rates. It does however show that the effects of monetary policy on expectations extend to long horizons and do not die after horizons of a few years.
Conclusion
To understand the effects of macroeconomic data surprises and monetary policy actions on financial markets, it is important to consider how these affect the entire cross section of interest rates. Such an analysis shows where on the time horizon market expectations of economic fundamentals have changed. Similar analysis of the term structures of real interest rates, inflation expectations, and risk premiums has the potential to reveal even more about how changes in economic fundamentals drive the term structure of interest rates.
Gürkaynak, Refet S., Brian Sack, and Jonathan H. Wright. 2007. “The U.S. Treasury Yield Curve: 1961 to the Present.” Journal of Monetary Economics 54(8), pp. 2291–2304.
Kuttner, Kenneth N. 2001. “Monetary Policy Surprises and Interest Rates: Evidence from the Fed Funds Futures Market.” Journal of Monetary Economics 47, pp. 523–544
This is the Press Release from Wednesday's FOMC meeting:
Press Release, Release Date: November 2, 2011, For immediate release: Information received since the Federal Open Market Committee met in September indicates that economic growth strengthened somewhat in the third quarter, reflecting in part a reversal of the temporary factors that had weighed on growth earlier in the year. Nonetheless, recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated. Household spending has increased at a somewhat faster pace in recent months. Business investment in equipment and software has continued to expand, but investment in nonresidential structures is still weak, and the housing sector remains depressed. Inflation appears to have moderated since earlier in the year as prices of energy and some commodities have declined from their peaks. Longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.
To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.
The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools to promote a stronger economic recovery in a context of price stability.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action was Charles L. Evans, who supported additional policy accommodation at this time.
Aftershocks, by Tim Duy: The reality of the worsening European situation came home to roost on Wall Street this week. Last week's "summit to end all summits" offered up only broad brush strokes to begin with, and even those were rapidly erased by plans for a Greek referendum on the deal. A rumor circulated earlier today that the referendum was dead, but that has since been refuted by the Greek government. It appears that either the Greek government collapses or the referendum will occur - and neither outcome is good for market participants looking for certainty in these uncertain times.
Let me suggest this as well - that even if Greece comes back on board with the existing agreement, the damage is already done. Three thoughts today:
A deepening Eurozone recession is inevitable. Even if full-blown financial crisis is avoided, the cost will be continued austerity programs that will sink the Eurozone economy ever deeper into recession. This will only exacerbate the problems facing European banks as nonperforming loans rise, which will be on top of the credit contraction to follow plans to have banks recapitalizing themselves with private money by next summer.
The unintended consequences of the EFSF. The EFSF was already a farce to begin with, underfunded and relying on leverage to cover up a lack of money. The farce continued as European leaders sought handouts from China to fund a project they themselves were not committed to. Then the lack of details within the latest plan is hampering the ability of the EFSF to issue debt. From the FT (hat tip to Zero Hedge):
The bond from the European financial stability facility will seek to raise €3bn ($4bn) and will be in 10-year bonds rather than a 15-year maturity because of worries over demand, say bankers. A 10-year bond is more likely to attract interest from Asian central banks than a longer maturity.
Bankers familiar with the issue said the EFSF had been considering a €5bn issue. However, the EFSF has denied this, saying it had always sought a €3bn issue...
...EFSF officials decided to price this week because market conditions might deteriorate if they hold off any longer, according to bankers.
The bond is expected to price at yields of about 3.30 per cent, about 130 basis points over Germany, the European market benchmark. This represents a big mark-up since the middle of September, when existing 10-year EFSF bonds were trading at about 2.60 per cent, only 70bp over Germany.
Now the insurance component of the EFSF is blowing back in their faces. From the FT:
“It is kind of ironic: it is Draghi’s first day. His first decision is ‘yes, buy Italian bonds’,” said Gary Jenkins, head of fixed income at Evolution Securities. He added that the move to make Europe’s rescue fund, the European financial stability facility, issue insurance on new Italian and Spanish debt was deterring buyers: “They have created a situation where the only people buying Italian debt are themselves.”
A trader of Italian government bonds said: “It was meltdown at one point before the ECB came in. There were no prices in Italian government bonds. That is almost unheard of in a big market like Italy. There were just no buyers and therefore no prices.”
By not creating a backstop for previously issued bonds, the Europeans have clearly identified those bonds at risk of default. If the Europeans are not willing to buy or insure the bonds, why should investors? Answer: They shouldn't. Consequently, the ECB was forced to do what it hates, buy Italian debt, and even then yields climbed above 6%, nearing levels that many believe is the point of no return for Italy.
Moreover, one should question the what is the meaning of "insurance" for Europe. I can't imagine the ESFS actually making good on any promises to insure bondholders, as the Europeans appear adept at defining defaults as "voluntary" and therefore not credit events covered by insurance.
Will the ECB be Europe's white knight? I think we all agree that lacking a lender of last resort, Europe has something of a credibility problem. As in, no credibility. And it has been pointed out repeatedly that the ECB could step into this role. After all, we are talking about the future of the Euro, which should be something of a concern for central bankers. And, as noted by Kash Mansori at The Street Light, by guaranteeing a price for Italian debt, the ECB would like have to buy far less than they think. But here is the problem - why should the Italians get an ECB backstop at 6%, while the Irish pay 8% and the Portuguese 12%? Politically, the ECB needs to backstop either everybody equally or nobody. Setting a ceiling on Italian debt alone risks setting off a firestorm of public anger within those nations already struggling under the weight of austerity programs. And note that even if the ECB does come into the fight, the will only do so in return for additional austerity. In other words, they might stave off financial collapse, but not recession.
Bottom Line: No matter how many summits they have, there is no easy out for the Europeans at this point.
1. Explain the shape of the reserve demand curve. (b) Explain the shape of the reserve supply curve.
2. 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.
3. 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.
4. 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?
5. Explain the speculative motive for holding money in Keynes liquidity preference theory and why, in aggregate, it is negatively related to the interest rate.
6. 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.
7. What did Tobin add to Keynes theory of the speculative demand for money? Why was this development important?
The U.S. Federal Reserve announced new figures Wednesday used to calculate next year’s reserve requirements for depository institutions.
For net transaction accounts–mostly checking accounts–the first $11.5 million in deposits will be exempt from reserve requirements in 2012, up from $10.7 million in this year.
The Fed will assess a 3% reserve ratio on net transaction accounts from $11.5 million up to $71.0 million, compared with a ceiling of $58.8 million this year.
And the Fed will assess a 10% reserve ratio on net transaction accounts in excess of $71.0 million. The Fed didn’t change the reserve ratios in its annual indexing announcement.
Banks must hold a percentage of net transaction accounts as reserves in the form of vault cash, as a deposit in a Federal Reserve Bank or as a deposit in a pass-through account at a correspondent institution, the Fed said.
“The actions we have taken recently will be helpful in supporting growth and jobs,” Federal Reserve Bank of New York President William Dudley said. “The Fed is doing — and will continue to do — everything in its power to promote jobs and price stability.”
But Dudley said, “I do not think that monetary policy is all powerful,” explaining that “to get the strongest possible recovery, we need reinforcing action in areas such as housing and fiscal policy.” The decision last month to sell $400 billion in its short-dated holdings and buy a like amount of longer-dated bonds “should provide some additional support for growth,” Dudley said. ...
While the Fed has only just embarked on the program markets call Operation Twist, speculation is growing that more stimulus in the form of expanded Fed purchases of mortgage assets could be around the corner. Dudley is widely viewed as being in sympathy with Fed Chairman Ben Bernanke and the other Fed officials who believe the central bank still can provide stimulus to the economy.
Dudley left open the possibility he’d support the Fed buying mortgage securities beyond what it is doing now. ...
The Fed has a considerable dissident faction that contend at a time when families and companies are cutting debt, making credit more affordable won’t do much to boost growth and bring down the unemployment rate. ...
Review Material for Midterm 1 Economics 470/570 Fall 2011
These are review questions for the first midterm exam which will be on Thursday, October 20.
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 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
Questions
Chapter 2
1. What are the functions of money, i.e. why does money exist? Relative to a barter economy, what problems are overcome by the use of money?
2. To be useful as a medium of exchange, what properties should money have?
3. Describe the evolution of money from barter to fiat money. How did paper money arise?
4. How is money measured? Why is there more than one definition of the money supply? Are data on the money supply reliable?
Chapter 3
5. Describe the main function of financial markets. Explain how direct finance and indirect finance differ.
Chapter 4
6. 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 11
7. 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.
8. 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.
9. 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.
10. Besides pooling risk, pooling small deposits, and pooling over time, what else do financial intermediaries do to increase the efficiency of financial markets?
11. Briefly, what does the phrase “increase the efficiency of financial markets” mean?
12. What is adverse selection? Give an example of adverse selection in financial markets. How can the adverse selection problem be overcome?
13. What is moral hazard? Give an example of moral hazard in financial markets. How can the moral hazard problem be overcome?
Chapter 16
14. Describe the structure of Federal Reserve districts and Federal Reserve district banks.
15. Briefly describe the major functions of Federal Reserve district banks.
16. How do member banks differ from other banks? How did the difference change in 1980?
17. Who is on the FOMC? What does the FOMC do?
18. Describe the structure and function of the Board of Governors of the Federal Reserve System.
19. How has the power structure of the Federal Reserve System shifted over time?
20. 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 17
21. 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?
22. 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.
23. 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.
24. 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.
This topic came up in class the other day (see here and here too):
Did Speculation Drive Oil Prices? Market Fundamentals Suggest Otherwise, by Michael D. Plante and Mine K. Yücel, Economic Letter, FRB Dallas: Oil market speculation became an especially popular topic when the price of crude tripled over 18 months to a record high $145 per barrel in July 2008. Of particular interest to many is whether speculators drove oil prices beyond what fundamentals would have otherwise justified. We explore this issue over two Economic Letters. In this article, we look at evidence from the physical market for oil and conclude that fundamentals, and not speculation, were behind the dramatic rise and fall in oil prices. In our companion Economic Letter, we examine the futures market.
Oil prices began their climb in 2002, reaching a record high in mid-2008, and then collapsed at the end of ’08 amid the global recession. As world economic growth picked up, so did oil prices. Overall, the year-over-year change in oil prices has fairly closely tracked world gross domestic product (GDP) growth (Chart 1).
Energy consumption increases as GDP rises; but energy consumption in developing countries increases almost twice as fast as in developed countries. GDP expansion in emerging economies was particularly strong between 2005 and 2007, averaging 8 percent per year. Real GDP in China, for example, grew by an average 12.7 percent annually between 2005 and 2007, while the nation’s oil consumption increased 5.1 percent annually during the period.
From the beginning of 2007 to mid-2008, weekly prices for West Texas Intermediate (WTI) crude oil jumped 152 percent, from $57 to $143 per barrel. It’s possible that growing demand for crude oil might not be the reason for the rise. However, if the increase was due to other factors, oil consumption should have begun falling in response to the higher prices. Instead, there was almost no consumption decline during the period, implying that oil prices were driven by growing world income and demand.
Insensitivity to Price Change Consumers of oil and oil products are not very sensitive to price changes, especially in the short run. In economic jargon, the price elasticity of demand is very low. This is mainly because oil’s use for transportation purposes accounts for two-thirds of consumption, especially in developed countries, where there are no close substitutes in the short term. When consumers are insensitive to price changes, a shock in the oil market, whether from increased demand or reduced supply, will heighten price volatility.
To see whether rising oil prices from 2007 through mid-2008 are compatible with the elasticities for oil estimated in the energy economics literature, we performed a simple calculation. Taking the developed-world and emerging market GDP growth rates from the International Monetary Fund, and making some assumptions about income elasticities of demand, we can calculate the higher oil demand implied by these growth rates. Then, by comparing actual growth in consumption and the calculated consumption numbers, we can determine the oil price elasticities they imply. We found that these elasticities would have to range from 0.01 to 0.08 for prices to surge as they did in 2007 and 2008—well within the estimated elasticity ranges in the energy economics literature.[1]
OPEC Market Power Firmed Prices The oil market is not perfectly competitive. The Organization of the Petroleum Exporting Countries (OPEC), since its formation in 1970, has been an oligopolistic producer, trying to boost prices by controlling members’ output (with more success at times of higher demand growth). The remaining non-OPEC producers form a price-taking, competitive fringe. OPEC’s market share has dwindled from 52 percent in the early 1970s to a still hefty 42 percent today. In the 1990s, as the market grew, so did both OPEC and non-OPEC production. However, non-OPEC oil output growth flattened around 2003, while OPEC output continued expanding from 37 percent in 2003 to the current 42 percent level. Increased market power, coupled with rising demand, was a significant factor keeping oil prices high.
Low OPEC Excess Capacity OPEC’s crude oil production capacity has changed little since the 1970s, rising from 34 million barrels per day in 1973 to 35.5 million barrels per day in 2008. However, increased world consumption greatly diminished the cartel’s excess capacity. OPEC has added capacity slowly, using its restrained output to keep prices high.
It is easier to keep cartel members disciplined and conforming to production quotas when capacity is tight. Moreover, shocks in a tight oil market can increase price volatility because OPEC lacks the ability to offset these shocks, even if it desires to. Chart 2 shows the inverse relationship of oil prices and the cartel’s excess capacity. In mid-2008, when oil prices reached record highs, OPEC excess capacity was down to 1 million barrels per day.[2]
Inventories Did Not Increase A speculator wanting to drive up the current price of oil would have to buy in the spot market. Since the price is determined in a cash marketplace where transactions are settled with physical oil changing hands, speculative buyers would have to store their purchases, and inventories would rise. Instead, during the oil price run-up in 2007 and 2008, inventories in the U.S. were being depleted. Chart 3 shows WTI prices and U.S. oil inventories and illustrates the workings of an efficient market—as supplies diminish, prices rise and the market tightens.
Another possibility might be speculators using floating storage, keeping oil in tankers at sea and off the market. Floating storage appears to increase in 2008, rising from 68.4 million barrels at the end of October to 97 million barrels in May (Chart 4). However, floating storage declined in June and continued falling throughout the summer.
We would have expected to see floating storage rise significantly during the summer if speculators were in the market; instead, the opposite occurred. Floating storage did rise much later in the year, but that was concurrent with the global recession.
There is one additional type of storage—producers maintaining the oil as reserves and not producing. However, if we look at OPEC output, it clearly rose as oil prices went up, until July 2008. OPEC increased production by 2.4 million barrels per day from the beginning of 2007 to July 2008. Non-OPEC production remained relatively constant and did not rise, though this is largely a function of non-OPEC producers’ zero excess capacity rather than an attempt to restrict output.
Other Commodities Surged Those believing speculation pushed up prices point to the coincident increase in the number of noncommercial traders in the futures market—for example, speculators—and the rise in oil prices.[3] However, Chart 5 shows that this may not necessarily be the case. It depicts the prices of WTI, Illinois Basin coal, tallow and cobalt. Of these commodities, there is a futures market only for WTI. Yet, prices for Illinois Basin coal, tallow and cobalt increased as fast as oil, if not faster, in 2008 and fell just as quickly when the economy crumbled. Such integrated movement in the prices of these commodities is consistent with a pure demand story, rather than a speculation one.
Fundamentals, Not Speculation Activity in the futures market increased appreciably in the past decade, as did the number of noncommercial traders. This rise was coincident with the rise in oil prices, leading some to hypothesize that speculation—rather than market fundamentals—drove the price of oil.
The tripling of oil prices from early 2007 to mid-2008 is consistent with several market fundamentals, including increased demand from emerging markets, low elasticities of demand and reduced OPEC excess capacity. The behavior of inventories was also consistent with the reality of a tight market, not with a story of speculation-driven hoarding, whether we look at inventories above ground, below ground or floating at sea. Hence, evidence from the physical market for oil, similar to that from the futures market, is consistent with oil-market fundamentals leading to increasing oil prices before the global recession.
Notes
An elasticity of 0.01 implies that for every 10 percent change in oil prices, consumption falls by 0.1 percent. Estimated short-run price elasticities for oil range from 0.0 to –0.11. See “A Literature Review of Demand Studies in World Oil Markets,” by Frank J. Atkins and S.M. Tayyebi Jazayeri, University of Calgary, Department of Economics Discussion Paper 2004-07, April 2004.
OPEC excess capacity has ranged from a high of 9.8 million barrels per day in 1985 to a low of 700,000 barrels per day in 2004.
Christopher Sims and Tests for Causality: To tell the full story of Christopher Sims' contributions to causality, we need to go back to the state of the art in policy evaluation in the 1960s, in particular, to something known as the St. Louis equation:
Yt = c + a0Mt + a1Mt-1 + a3Mt-2 + b0Gt + b1Gt-1 + b2 Gt-2 + et
In this equation, output (Y) is regressed on current and lagged values of money (M) and government spending (G). The idea was to see how output responded historically to changes in money and government spending, and then use these estimates to guide policy. If we know how Y responds to M, then we can use that knowledge to set monetary policy optimally.
Now, there is a fundamental problem with this approach highlighted by the Lucas critique (the negative reaction to the other common approach, using large-scale structural models to evaluate policy, was discussed yesterday). If you change monetary policy you also change the values of the a and b coefficients so that the estimates are no longer reliable, and hence no longer a guide, but that criticism came later. At the time there was another worry.
The worry was something known as simultaneity bias. Consider the Mt term in the equation above. If Mt is "econometrically exogenous," i.e. if it doesn't depend upon Yt, then the estimated value of a0 will be unbiased. But if Mt depends upon Yt , perhaps through and equation such as Mt = h0 + h1Yt + ut, then the estimate of will be biased and hence a poor guide to policy decisions.
The first use of causality tests was to test to see if h1 in the "policy equation" was equal to zero, and Sims was a key player in the development of these tests. Thus, Sims starts his 1972 AER paper with:
This study has two purposes. One is to examine the substantive question: Is there statistical evidence that money is "exogenous" in some sense in the money-income relationship? The other is to display in a simple example some time-series methodology not now in wide use. The main methodological novelty is the use of a direct test for the existence of unidirectional causality.
If there was unidirectional causality from M to Y, then the estimate would be unbiased. But if there was two-way causality, i.e. if Y causes M (h1 is not zero), then the estimate would be problematic.
Sims contributed greatly to this literature, and once this work was largely complete, it quickly became clear that these tests could be used to assess causality more generally, the method was not limited to checking for econometric exogeneity.
But there was also a problem. The basic technique (an F-test on a set of coefficients) to test for causality worked well on 2-variable systems, but it didn't work reliably for systems with three or more equations (the problem was that X can cause Y, and Y can then cause Z so that there is a causal path from X to Z, but the F-test approach will miss this).
Sims Second major paper on causality addresses this problem by providing two new tools to assess causality, impulse response functions and variance decompositions (along the way it was also shown that Sims and Granger causality are equivalent). Impulse response functions, which have since become a key analytical device in macroeconomics, trace out the response of the variables in the model to a shock to another variable in the system (identification restrictions are needed to ensure that the shock is actually a policy shock, see here). If the variable, say output, responds robustly to a shock to, say, the federal funds rate, then we say that the federal funds rate causes output. But if we shock the federal funds rate and output essentially flat-lines in response, then causality is absent.
However, even when there is causality according to the impulse responses, impulse response functions do not tell us how important one variable is in explaining the variation in another variable (the impulse response function could look impressive, but it may be that we are only explaining 1% of the total variation in the other variable so that the response we are seeing is not very important in explaining why the other variable fluctuates over time). Variance decompositions solve this problem. They don't tell you the sign/pattern of the response like impulse response functions do, but the do give an indication of how important one variable is in explaining the variation in another variable (e.g. if M explains 75% of the variance in output, that's impressive and notable, but if it's only 1% then money isn't very important in explaining why output changes over time).
Sims second paper also made another important point. In his first paper, he found that money causes output (so it could not be treated as econometrically exogenous as in the St. Louis equation). But that was in a two-variable system including only M and Y. In his second paper he adds interest rates (i) and prices (P) to get a four variable system, and he finds that this overturns the results in his first paper. Once i is added to the model, M no longer causes Y. Thus, the lesson is that if you leave important variables out of a VAR system, it can produce misleading results.
But Sims' main contributions were, initially, the F-tests for testing causality in bivariate systems, and the addition of IRFs and VDCs to assess causality in higher order systems. In addition, he also provided many of the common "pitfalls of causality testing," -- causality testing can be misleading in a number of ways. One is above, leaving a variable out of a system. If A causes B to change tomorrow, and C to change the next day, a system containing only B and C will look as though B causes C when in fact there is no causality at all, a third variable causes both. Other pitfalls can occur, for example, when there is optimal control or when expectations of future variables are in the model. Identifying the pitfalls of the methods he (and others) developed was also an important contribution to the literature.
Sims' work on causality was highlighted in the Nobel announcement, and I hope this provided some background on this topic. But there's a lot more to be said about Sims' work over and above his work on causality testing discussed above and his work on structural VARs I discussed yesterday, e.g. his recent papers on rational inattention, and I hope to write more about both Sims and Sargent when I can find the time.
The economy was not in recession in the third quarter, which means the backward looking data flow through this month will not be particularly dire.
Consistent with this prediction, the September employment report painted a picture of an economy still wading through knee-deep mud, but not in economic collapse. That said, prior to the report, Barry Ritholtz offered some wisdom regarding individual data points versus trends:
What does matter is the overall vector of a given economic sector. Vectors include the rate of acceleration or deceleration, persistency, direction etc. Think overall “trend” and changes thereto. For employment, this means: Are we seeing an increase in the factors that lead to hiring? What is the ratio between hires at big firms vs small firms? Are Wages increasing, staying flat, or decreasing; Temp workers getting hired, total hours worked etc. What are the likely data and modeling errors? Collectively, those factors all add up to an issue of the employment situation roughly improving, maintaining a stability, or getting worse.
Hence, each data point should be looked at in terms of whether it is continuing the overall trend, or suggesting a reversal in trend. Everything else is noise.
With trends in mind, the data did little to dispel my concern that private sector hiring rolled-over earlier this year, especially when combined with last week's read on employment via the ISM nonmanufacturing report:
A string of stronger-than-projected statistics -- capped by the news on Oct. 7 of a 103,000 rise in payrolls last month --has prompted economists at Goldman Sachs Group Inc. and Macroeconomic Advisers LLC to raise their growth forecasts for third quarter growth to 2.5 percent from about 2 percent. That’s nearly double the second quarter’s 1.3 percent rate and would be the fastest growth in a year.
“The U.S. economy doesn’t look like it’s double-dipping at all,” said Allen Sinai, president of Decision Economics Inc. in New York. “But it is a crummy recovery.”
The article offers up the usual caution on Europe and increasingly tight fiscal policy when the New Year begins. But the bottom line is correct - on the basis of existing data, the recession call looks like a long-shot.
Getting to the recession call requires generally ignoring the incoming data on the real economy and instead focusing on financial markets. Then recognize that in recent experience, financial distress leads to broader economic distress. Moreover, at the moment, the slowdown in US economic growth coupled with the possibility of sovereign default in Europe are combining in such a way as to expose the inherent vulnerabilities in a still-under-capitalised global financial system. See Edward Harrison here.
And although there is optimism the European situation can be resolved in three weeks, they seem to be walking a very fine line between attempting to recapitalize the banking system without undermining sovereign debt ratings while maintaining what effectively amounts to a pegged exchange rate system that is fundamentally inconsistent with the economic needs of more than one nation. In addition, they have an odd situation where every nation needs to issue Euro-denominated debt, but no nation can actually print Euros as a backstop. It's as if each nation issues only foreign-denominated debt, with ultimately no lender of last resort on a national level. Of course, the European Central Bank could fill this role, but will they?
My experience is that when a financial landscape is as ugly as we see here, there is no rescue plan. Things tend to get much worse before they get better. That seems to be what financial market are telling us.
With that cheery thought in mind, I offer another distressing correlation. While I generally find monetary aggregates difficult indicators in the best of time, this caught my attention:
Since the end of the 1990's, there has been a negative correlation between M2 growth and industrial production growth. It appears that financial market disruptions of the current magnitude are sufficient to drive substantial changes in spending. If this correlation continues to hold, then I need to rethink my belief that any recession in the near term will be relatively mild considering the lack of rebound from the last recession. Perhaps underneath today's seemingly comforting data something very ugly is brewing. Which means enjoy these big rallies on Wall Street while you can.
1. 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?
2. Besides pooling risk, pooling small deposits, and pooling over time, what else do financial intermediaries do to increase the efficiency of financial markets?
3. Who is on the FOMC? What does the FOMC do?
4. How has the power structure of the Fed changed over time?
If you squint your eyes near the end of the sample, you'll see that Operation Twist appeared, on impact, to move short and long inflation expectations in opposite directions. The effect did not last long, however. The march downward continues--for now, at least.
Expected inflation over the next five years has fallen to less than 1.5% based on measures in the market for Treasury Inflation Protected Securities, or TIPS. That is down from nearly 2.5% in April.
“That is making me a little bit worried,” Mr. Bullard said, because it could be a sign that inflation could drop well below the Fed’s informal 2% objective and that there is a greater risk of deflation, or falling consumer prices. If economic activity continued to weaken or if the economy were to be hit by another shock, then inflation expectations could decline substantially below the Fed’s objectives, he said.
The Fed last year pointed to the risk of deflation as a reason to launch a bond-buying program known as quantitative easing. Mr. Bullard said that while the market now is suggesting a growing risk of deflation, he does not see deflation as likely, but rather something to keep an eye on. The bar to another round of quantitative easing was still high “at this point,” he said. ...
Fed Chairman Ben Bernanke also said Wednesday the Fed is watching price trends very closely given the decline in market-based measures of inflation expectations. ... The chairman had been asked about the moves in the TIPS market. He said that in surveys, respondents expect that price increases will average around 2% over the coming years, which is where the central bank wants them. ...
1. 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.
2. What is meant by the term "fractionally backed currency"? How does fractionally backed currency come about?
3. 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%?
4. 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 explain how pooling small deposits through financial intermediation can increase the efficiency of financial markets.
5. 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.
6. Briefly, what does the phrase “increase the efficiency of financial markets” mean?
“The transmission mechanism for monetary policy remains somewhat impaired, and for this reason I am not expecting large gains from the Fed’s most recent action,” Federal Reserve Bank of Atlanta President Dennis Lockhart said.
Lockhart was referring to the decision of the Fed last week to implement what many in financial markets are calling Operation Twist. The central bank announced it would sell some $400 billion of its shorter dated holdings and buy longer dated bonds, in a bid to lower borrowing costs and improve a moribund state of economic activity.
The effort is “a measured, incremental attempt to add more support to the recovery. It’s not a fix for everything that ails the economy, but it should help,” Lockhart said. ...
Lockhart, in his speech Tuesday, sought to condition how Operation Twist is seen, and he also signaled it’s possible the Fed could take additional action to help the economy. ...
“I don’t see a recurrence of economic contraction. That said, we are in a period of greater risk and uncertainty,” the official warned. “I expect the pace of the recovery to build, albeit modestly, and this will bring a gradual reduction in unemployment,” Lockhart said. He expects the U.S. gross domestic product to rise 1% to 2% this year and 2% to 3% next year.
“The European debt crisis looms as the biggest threat at the moment, in my opinion,” he said. ...
Tests: There will be two midterms and a final. The midterms will be given on Thursday, October 20th and on Tuesday, November 15th. The final will be given on Monday, December 5th from 1:00 p.m. – 3:00 p.m.
Homework: Problem sets will be assigned periodically. These are graded, and exam questions will be based, in part, upon the problem sets. I will explain more about how the problem sets will be graded in class.
Grading: The midterms are worth 40% (20% each), the homework counts as 20%, and the final is worth 40%. Grades will be assigned according to your relative standing in the class.
Students with Disabilities: If you have a documented disability and anticipate needing accommodations in this course, please make arrangements with me during the first week of the term. Please request that the counselor for students with disabilities (164 Oregon Hall) send me a letter verifying your disability.
Course Outline:
Introduction
Text Chapters
Introduction; Money and the Payments System
Ch. 2
Financial Instruments, Markets, and Institutions
Ch. 3, 4 (pgs. 86-90)
The Economics of Financial Intermediation
Ch. 11
Central Banking and the Conduct of Monetary Policy
Structure of Central Banks and the Federal Reserve System
Ch. 16
Multiple Deposit Creation and the Money Supply Process
Ch. 17
Tools of Monetary Policy
Ch. 18
Monetary Theory
Money Growth, Money Demand, and Monetary Policy
Ch. 20
Output, Inflation, and Monetary Policy
Ch. 21
Understanding Business Cycle Fluctuations
Ch. 22
The Challenges Facing Central Bankers (time permitting)
