Economics 470/570 - Monetary Theory and Policy

Lecture 17 on Tuesday 11/29/2012

Brief Outline of Topics Covered in Lecture 17

• Summary and Overview
• Answer Questions

Video

Extra Reading:

Tim Duy:

A Little Less Dovish..., by Tim Duy: In the midst of an internal debate over policy communication, Chicago Federal Reserve President Charles Evans pulled back on his 3 percent inflation threshold in a speech yesterday. Arguably, as the only policymaker suggesting guidance well above the Fed's stated 2 percent target, Evans was the last true dove at the Fed. With Evan's falling in line with his colleagues, it looks like the last sliver of hope that the Fed would tolerate slightly higher inflation to accelerate the reduction of real burden has now been dashed.

There is a lot of interesting material in Evan's speech, but here I focus only on his basic outlook and the implications for policy. Regarding growth:

That said, monetary policymakers must formulate policy for today. In the United States, forecasts by both private analysts and FOMC participants see real GDP growth in 2012 coming in at a bit under 2 percent. Growth is expected to move moderately higher in 2013, but only to a pace that is just somewhat above potential. Such growth would likely generate only a small decline in the unemployment rate.

Of course, he added earlier that this forecast is vulnerable to the possible of an austerity bomb in 2013, but for the moment assume that issue is resolved:

Having said all that, most forecasters are predicting that the pace of growth will pick up as we move through next year and into 2014. Underlying these projections is an assumption that fiscal disaster will be avoided—and with this, that some important uncertainties restraining growth should come off the table. Also, deleveraging will run its course, and as it does, the economy’s more-typical cyclical recovery dynamics will take over. As the FOMC indicated in its policy moves last September, the current highly accommodative stance for monetary policy will be kept in place for some time to come.

He then praises recent policy actions:

Tying the length of time over which our purchases will be made to economic conditions is an important step. Because it clarifies how our policy decisions are conditional on progress made toward our dual mandate goals, markets can be more confident that we will provide the monetary accommodation necessary to close the large resource gaps that currently exist; additionally, markets can be more certain that we will not wait too long to tighten if inflation were to become an important concern.

And then tackles a big question:

The natural question at this point is to ask: What constitutes substantial improvement in labor markets? Personally, I think we would need to see several things. The first would be increases in payrolls of at least 200,000 per month for a period of around six months. We also would need to see a faster pace of GDP growth than we have now — something noticeably above the economy’s potential rate of growth.

From Evan's perspective, these conditions would be sufficient to end the expansion of the balance sheet, although interest rates will remain near zero beyond that point. When should rates rise?

Of course, we will not maintain low rates indefinitely. For some time, I have advocated the use of specific, numerical thresholds to describe the economic conditions that would have to occur before it might be appropriate to begin raising rates.

On the employment mandate:

In the past, I have said we should hold the fed funds rate near zero at least as long as the unemployment rate is above 7 percent and as long as inflation is below 3 percent. I now think the 7 percent threshold is too conservative....This logic is supported by a number of macro-model simulations I have seen, which indicate that we can keep the funds rate near zero until the unemployment rate hits at least 6-1/2 percent and still generate only minimal inflation risks.

So he shifts to a 6.5 percent threshold for unemployment, and later argues that even this might be a bit conservative as his models don't foresee much inflation pressure before 6 percent. See also Federal reserve Janet Yellen's recent speech; Evans' view is consistent with the optimal path forecasts. On one hand this is somewhat of a shift to the dovish side on the inflation forecast, suggesting that inflation will not accelerate as quickly as some might expect. What about the threshold for the rate of inflation itself?

With regard to the inflation safeguard, I have previously discussed how the 3 percent threshold is a symmetric and reasonable treatment of our 2 percent target. This is consistent with the usual fluctuations in inflation and the range of uncertainty over its forecasts. But I am aware that the 3 percent threshold makes many people anxious. The simulations I mentioned earlier suggest that setting a lower inflation safeguard is not likely to impinge too much on the policy stimulus generated by a 6-1/2 percent unemployment rate threshold. Indeed, we’re much more likely to reach the 6-1/2 percent unemployment threshold before inflation begins to approach even a modest number like 2-1/2 percent.

So, given the recent policy actions and analyses I mentioned, I have reassessed my previous 7/3 proposal. I now think a threshold of 6-1/2 percent for the unemployment rate and an inflation safeguard of 2-1/2 percent, measured in terms of the outlook for total PCE (Personal Consumption Expenditures Pride Index) inflation over the next two to three years, would be appropriate.

Notice that he really doesn't have a reason to shift his threshold; he doesn't even expect to hit the inflation threshold before hitting the employment threshold. His reason for essentially is that the 3 percent threshold makes people "anxious." Anxious about what? Anything that is perceived to be a threat to the Fed's credibility.

Does this shift on Evans' part really change anything? Probably not. He was always an outlier among Fed policymakers, with a tolerance for inflation as high as 3 percent making him a true dove. But he was never going to get any additional traction on that front from his colleagues. The 2 percent target is set in stone, and it is too much to expect the Fed will tolerate any meaningful deviations from that target. Of course, it is questionable that 3 percent is a meaningful deviation to begin with, but that is question is almost irrelevant at this point.

Bottom Line: By shifting his threshold on inflation, Evan's concedes to the political realities within the Fed. There was never much support for anything like tolerance for 3 percent inflation; for most policymakers, I suspect anything above 2.25 percent would be considered a threat to credibility. By falling in line with the rest of the FOMC, Evan abandons his role as a true dove, someone willing to tolerate substantially higher inflation. He is a dove now in the modern sense - a policymaker with a lower inflation forecast that allows for a longer period of easier policy.

Lecture 16 on Tuesday 11/27/2012

Brief Outline of Topics Covered in Lecture 16

Chapter 24 The Role of Expectations in Monetary Policy [continued]

The Lucas Critique of Econometric Policy Evaluation

Rules versus Discretion

• Discretion and Time-Inconsistency
• Types of rules
• The case for rules
• The case for discretion
• Constrained Discretion

The role of credibility and a nominal anchor

Credibility and aggregate demand shocks

• Positive and negative  AD shocks
• AS shocks
• Credibility and anti-inflation policy

Video

Extra Reading:

This Economic Letter from the SF Fed is on government spending multipliers:

Highway Grants: Roads to Prosperity?, by Sylvain Leduc and Daniel Wilson, FRBSF: Increasing government spending during periods of economic weakness to offset slower private-sector spending has long been an important policy tool. In particular, during the recent recession and slow recovery, federal officials put in place fiscal measures, including increased government spending, to boost economic growth and lower unemployment. One form of government spending that has received a lot of attention is public investment in infrastructure projects. The 2009 American Recovery and Reinvestment Act (ARRA) allocated $40 billion to the Department of Transportation for spending on the nation’s roads and other public infrastructure. Such public infrastructure investment harks back to the Great Depression, when programs such as the Works Progress Administration and the Tennessee Valley Authority were inaugurated.

One criticism of public infrastructure programs is that they take a long time to put in place and therefore are unlikely to be effective quickly enough to alleviate economic downturns. The fact is, though, that surprisingly little empirical information is available about the effect of public infrastructure investment on economic activity over the short and medium term.

This Economic Letter examines new research (Leduc and Wilson, forthcoming) on the dynamic effects of public investment in roads and highways on gross state product (GSP), the total economic output of a state. This research focuses on investment in roads and highways in part because it is the largest component of public infrastructure in the United States. Moreover, the procedures by which federal highway grants are distributed to states help us identify more precisely how transportation spending affects economic activity.

We find that unanticipated increases in highway spending have positive but temporary effects on GSP, both in the short and medium run. The short-run effect is consistent with a traditional Keynesian channel in which output increases because of a rise in aggregate demand, combined with slow-to-adjust prices. In contrast, the positive response of GSP over the medium run is in line with a supply-side effect due to an increase in the economy’s productive capacity.

We also assess how much bang each additional buck of highway spending creates by calculating the multiplier, that is, the magnitude of the effect of each dollar of infrastructure spending on economic activity. We find that the multiplier is at least two. In other words, for each dollar of federal highway grants received by a state, that state’s GSP rises by at least two dollars.

The Federal-Aid Highway Program

The federal government’s involvement in financing road construction goes back to the early part of the past century. Although initially small, this involvement became much more significant in 1956 with the enactment of the Federal-Aid Highway Act, which authorized almost $34 billion in 1956 dollars over 13 years for the construction of the Interstate Highway System. At the time, The New York Times noted that “the highway program will constitute a growing and ever-more-important share of the gross national product … (affecting) every phase of economic life in this country.”

The Interstate Highway System was completed in 1992. Since then, the federal government has continued to provide funding to states mostly through a series of grant programs collectively known as the Federal-Aid Highway Program (FAHP). The FAHP helps fund construction, maintenance, and other improvements on a wide range of public roads beyond the interstate highways. Local roads are often considered federal-aid highways and are eligible for federal funding, depending on how important the federal government judges them to be.

Because road projects typically take a long time to complete, advance knowledge of future funding sources can help smooth planning. Congress designs transportation legislation to minimize uncertainty. First, it enacts legislation that typically extends five to six years. Second, it apportions funds to states according to set formulas. Thus, a typical highway bill will specify an annual national amount for each highway program over the life of the legislation and spell out the formula by which that program’s national amount will be apportioned to states. Importantly, these formulas are based on road-related metrics measured several years earlier. That means that changes to current and future highway funding are not driven by current economic conditions.

Highway bills generally include information that helps states forecast relatively accurately the amount of grants they are likely to receive while the legislation is in effect. For the past two highway bills, the Federal Highway Administration (FHWA) published forecasts of each state’s annual future grants under each program.

Estimating the effects of road spending

We conduct a statistical analysis to estimate the effects of federal highway spending on state economic activity. Specifically, we construct a variable that captures revisions to forecasts of current and future highway grants to the states, based on information from highway bills since 1991. We closely follow, but also expand on, the FHWA’s methodology for forecasting each state’s future grants.

These forecast revisions serve as proxies for changes in expectations about current and future highway spending in a given state. In economic terms, these changes can be regarded as shocks, that is, unanticipated events that affect economic activity.

We study forecast revisions rather than changes in actual highway spending for two reasons. First, actual spending may both affect and be affected by current economic conditions, making it difficult to sort out the true causal effects of the spending.

Second, changes in actual spending are most likely to be anticipated years in advance. For that reason, some of their economic effects may be felt before the spending changes actually take place. For instance, a state government and other important players, such as construction and engineering firms, may decide to spend more today if they expect the state to receive more highway grants in the future. In this way, changes in expectations regarding future grants to the states may be important for current economic activity. Failing to account for changes in expectations may lead to incorrect conclusions about how government spending affects economic activity (see Ramey 2011a).

Figure 1
Average response of state GDPs to unexpected grants

In our analysis of how changes in forecasts of highway grants to the states affect state GSP, we control for lags in state GSP, lags in receipt of highway grants, average state GSP levels, and national movements of gross domestic product (GDP) over the sample period from 1990 to 2010.

In Figure 1, the solid line shows the average percentage change in a state’s GSP following a 1% increase in forecasted future highway grants to the states. The shaded area around the line represents a 90% probability range. The horizontal axis indicates the number of years after the unanticipated change in forecasted highway grants to the states. The figure shows that changes in the forecasts have a significant short-term effect on state output in the first one to two years. This effect fades, but then increases sharply six to eight years after the forecast revisions, before declining again. This pattern holds up well with alternative estimation techniques, the inclusion of different control variables, and with different data samples.

This pattern is consistent with New Keynesian theoretical models in which public infrastructure, such as roads, are used by the private sector in the production of goods and services and take time to be built (see Leduc and Wilson, forthcoming). In this framework, the initial impact is due to a traditional Keynesian effect of an increase in aggregate demand. The medium-term effect on output arises once the public infrastructure is built, thus increasing the economy’s productive capacity.

The highway grant multiplier

One concept often used to assess the effectiveness of government spending is the multiplier. The fiscal multiplier represents the dollar change in economic output for each additional dollar of government spending. Thus, a multiplier of two implies that, when government spending increases by one dollar, output rises by two dollars.

Based on the results shown in Figure 1, we find that multipliers for federal highway spending are large. On initial impact, the multipliers range from 1.5 to 3, depending on the method for calculating the multiplier. In the medium run, the multipliers can be as high as eight. Over a 10-year horizon, our results imply an average highway grants multiplier of about two.

Our estimated multipliers are noticeably larger than those typically found in the literature on the effects of government spending. For instance, in a recent survey, Valerie Ramey reports multipliers between 0.5 and 1.5 (see Ramey 2011b). One possible reason for the wide differences is that we consider a very different form of government spending. Most of the literature concentrates on the multiplier effect of military spending. But such spending is arguably nonproductive in an economic sense. By contrast, government investment in infrastructure, such as roads, can raise the economy’s productive capacity. In that respect, it can have a higher fiscal multiplier. Another difference is that we concentrate on the multiplier effect on GSP, while the literature typically studies the effect on U.S. GDP as a whole.

The American Recovery and Reinvestment Act

The deep recession of 2007–09 led to the enactment of ARRA, which included a large one-time increase of $27.5 billion in federal highway grants to states. ARRA was designed to have strong short-term effects. In general, infrastructure projects are not viewed as effective forms of short-term stimulus because of the long lags between authorization, planning, and implementation. By the time the projects get under way, a recession may be over. The extra spending could ultimately end up feeding an already booming economy. To address this problem, ARRA stipulated that state governments had to fully use their share of federal highway grants by March 2010.

It is conceivable that highway spending during a major downturn, when productive capacity is underutilized, may affect output in a substantially different way than spending during more normal times. To test this, we examined whether unanticipated changes in highway spending in 2009 and 2010 had a different effect on GSP than in other years in our sample. We found that spending in 2009 and 2010 was roughly four times as large as the peak response shown in Figure 1. This suggests that highway spending can be effective during periods of very high economic slack, particularly when spending is structured to reduce the usual implementation lags.

Conclusion

Surprise increases in federal investment in roads and highways appear to have had positive effects on gross state product in both the short and medium run. The short-run impact is akin to the traditional Keynesian effect that stems from an increase in aggregate demand. By contrast, the positive impact on GSP in the medium run is probably due to supply-side effects that boost the economy’s productive capacity. Infrastructure investment gets a good bang for the buck in the sense that fiscal multipliers—the dollar of increased output for each dollar of spending—are large.

References

Leduc, Sylvain, and Daniel J. Wilson. Forthcoming. “Roads to Prosperity or Bridges to Nowhere? Theory and Evidence on the Impact of Public Infrastructure Investment.” NBER Macroeconomics Annual 2012.

Ramey, Valerie A. 2011a. “Identifying Government Spending Shocks: It’s all in the Timing.” Quarterly Journal of Economics 126(1), pp. 1–50.

Ramey, Valerie A. 2011b. “Can Government Purchases Stimulate the Economy?” Journal of Economic Literature 49(3), pp. 673–685.

Homework 7

Economics 470/570
Monetary Theory and Policy
Homework 7

1. Use the Phillips curve model to explain the SR and LR effects of expected and unexpected changes in the inflation rate..

2. Does stabilizing the inflation rate stabilize the economy? Explain.

3. What problems are encountered in the pursuit of activist policies?

4. Explain how demand pull inflation can occur.

5. What is the Lucas critique of econometric policy evaluation?

6. What are the arguments for and against rules over discretion?

7. Show that credibility of the Fed helps to stabilize the economy when there are negative AD shocks.

Lecture 15 on Tuesday 11/20/2012

Brief Outline of Topics Covered in Lecture 15

Chapter 23 Monetary Policy Theory [continued]

Response of monetary policy to shocks

• Response to an AD Shock
• Response to a permanent supply shock
• Response to a temporary supply shock
• Summary

How active should policymakers be?

Is inflation always a monetary phenomenon?

• Causes of inflationary monetary policy

Chapter 24 The Role of Expectations in Monetary Policy

The Lucas Critique of Econometric Policy Evaluation

Rules versus Discretion

• Discretion and Time-Inconsistency
• Types of rules
• The case for rules
• The case for discretion
• Constrained Discretion

The role of credibility and a nominal anchor

Credibility and aggregate demand shocks

• Positive and negative  AD shocks
• AS shocks
• Credibility and anti-inflation policy

Video

Extra Reading:

I mentioned thresholds versus triggers last class:

Distinguishing Between a Fed Threshold and Trigger, by Neal Lipschutz, WSJ: Break out the dictionaries. We are likely to be hearing a lot about the word threshold, and how it is different from the word trigger...

Eric S. Rosengren, president of the Federal Reserve Bank of Boston, took on the threshold versus trigger issue at some length in a Nov. 1 speech.

“I think of a trigger as a set of conditions that necessarily imply a change in policy,” he said in the speech text. “A threshold, unlike a trigger, does not necessarily precipitate a change in policy.”

Later he added, “A threshold precipitates a discussion and more thorough assessment of appropriate policy, versus a trigger which starts a change of policy.”

Why wouldn’t the Fed immediately shift policy if its thresholds for employment and inflation were met?

Mr. Rosengren offered one example. “Suppose we reach one’s threshold unemployment rate but at that time the economy is slowing, and no further improvement in the unemployment rate is expected in the short to medium term,” he wrote in the Nov. 1 speech text. “This hypothetical situation would not necessarily imply a change in policy stance …”

Banking in 1947

[via]

Lecture 14 on Thursday 11/15/2012

Brief Outline of Topics Covered in Lecture 14

Chapter 22 - Appendix - The Phillips Curve and the SRAS Curve

The Phillips curve 

• The PC in the 1960's: A permanent tradeoff
• The Friedman-Phelps augmented PC
• The modern PC (adds supply shocks)
• The modern PC with Adaptive Expectations
• Okun's law and the SRAS

Chapter 23 Monetary Policy Theory [probably won't get very far into this chapter]

Response of monetary policy to shocks

• Response to an AD Shock
• Response to a permanent supply shock
• Response to a temporary supply shock
• Summary

How active should policymakers be?

Is inflation always a monetary phenomenon?

• Causes of inflationary monetary policy

Video

Extra Reading:

Tim Duy:

Yellen Supports Explicit Guideposts, by Tim Duy: Today Federal Reserve Vice Chair Janet Yellen discussed the evolution of policy communications. As might be expected from Yellen, there was a dovish tone to the speech. She provides a very nice overview of the Fed's changing communication strategy before shifting to her preferred path for the future. Along the way, she reiterates her estimated optimal path for monetary policy:

The notable feature of the optimal path is that inflation glides to its long-run target from above while unemployment does the opposite. These path are achieved by holding down interest rates longer than the level implied by a Taylor-type rule. Yellen explains that it is challenging to communicate such a rule, particularly in the current circumstances:

The fact that simple rules aren't as useful in current circumstances as they would be for the FOMC at other times poses a significant challenge for FOMC communications, especially since private-sector Fed watchers have frequently relied on such rules to understand and predict the Committee's decisions on the federal funds rate...

...Now, however, the federal funds rate may well diverge for a number of years from the prescriptions of simple rules. Moreover, the FOMC announced an open-ended asset purchase program in September, and there is no historical record for the public to use in forming expectations on how the FOMC is likely to use this tool. Thus, the current situation makes it very important that the FOMC provide private-sector forecasters with the information they need to predict how the likely path of policy will change in response to changes in the outlook...

How can the Fed augment the current communication strategy of an expected time frame for exceptionally low rates coupled with broad economic objectives to be met prior to changing policy? First, more explicit forecasts:

One logical possibility would be for the Committee to publish forecasts akin to those I've presented in figure 1. That is, the Committee could provide the public with its projections for inflation and the unemployment rate together with what it views as appropriate paths both for the federal funds rate and its asset holdings, conditional on its current outlook for the economy.

Yellen notes, however, that the Fed's institutional structure relies on 19 forecasts, which is challenging to synthesize into a single forecast. Research in this area is ongoing. She then supports the basic approach advocated by Chicago Federal Reserve President Charles Evans and Minneapolis Federal Reserve President Narayana Kocherlakota:

Another alternative that deserves serious consideration would be for the Committee to provide an explanation of how the calendar date guidance included in the statement--currently mid-2015--relates to the outlook for the economy, which can and surely will change over time. Going further, the Committee might eliminate the calendar date entirely and replace it with guidance on the economic conditions that would need to prevail before liftoff of the federal funds rate might be judged appropriate. Several of my FOMC colleagues have advocated such an approach, and I am also strongly supportive. The idea is to define a zone of combinations of the unemployment rate and inflation within which the FOMC would continue to hold the federal funds rate in its current, near-zero range.

While I like explicit targets in theory, I have been concerned that monetary policy is too complex to summarize in two numbers, thus making it a communications nightmare rather than a dream. Perhaps I am too pessimistic. Yellen offers a response:

Under such an approach, liftoff would not be automatic once a threshold is reached; that decision would require further Committee deliberation and judgment.

Not a fixed target that requires action, just consideration of action. Whether the rest of the FOMC follows suit with this approach is another question, but the winds are definitely blowing in that direction. On average then, this is relatively dovish. The Fed is heading toward a policy direction that would explicitly allow for inflation somewhat above target and unemployment below target as long as inflation expectations remained anchored. One would think this should put upward pressure on near term inflation. But Ryan Avent notes the opposite is occuring:

But since mid-October, there has been an unmistakable reversal in the inflation-expectations trend. Based on 5-year breakevens, all of the September spurt has been erased. And 2-year breakevens are back at July levels. Given my optimism over the Fed's September moves and the apparent strength of underlying fundamentals in the economy, I would like to disregard this trend, but one should be very reluctant to abandon guideposts that have served one well just because they've moved in an inconvenient way.

Graphically:

Avent has a point here (with the caveat that TIPS-based inflation expectations might be less than perfect). He also expressed concern about a broader array of assets:

Other proxies for demand—equity prices, bond yields, and the level of the dollar—have also moved, albeit modestly, in worrying ways. The S&P 500 is down a bit over 5% from its September high, the 10-year Treasury yield has fallen more than 20 basis points since October, and the trade-weighted dollar, which plunged after the Fed's September meeting, has been strengthening since the middle of last month.

I would add that Yellen's speech did not even generate a knee-jerk response in the stock market today. I remember a time not long ago when any hint of dovishness was good for a 1% rally. Which, combined with Avent's thoughts, leaves me wondering if open-ended QE is the last of the Fed's monetary tools. We now know the Fed will continuously exchange cash for Treasury or mortgage bonds until the Fed's economic objectives are met. Uncertainty about the course of monetary policy as been largely eliminated. There is not likely to be a premature policy reversal. What if the pace of the economy does not accelerate, sustaining a large, persistent output gap and a low inflation environment? The Fed could increase the pace of purchases, but would this really change expectations? Can we get more "open-ended?"

Bottom Line: Yellen delivers a dovish speech, siding with Evans and Kocherlakota who had previously advocated explicit inflation and unemployment guidelines for policy change. The Fed is moving in this direction, promising to further lock-in a program of aggressive large scale asset purchases. But is this the end of the road for policy? "Open-ended" sounds much like "unlimited." And unlimited sounds like the end of the road. If the economy stumbles, will the Fed pull a new trick out of its policy bag, or is that bag finally empty? And if that bag is empty, then we will need to turn to fiscal policy if the economy stumbles. This is worrisome given the expected path of fiscal policy - tighter, just degrees of tighter. Which means for the moment we just cross our fingers and hope the economy gains traction on the back of housing and accelerates as 2013 progresses.

Homework 6

Economics 470/570
Monetary Theory and Policy
Homework 6

1. How does the effectiveness of monetary policy change when there is a decrease in the responsiveness of investment to the interest rate? What does this imply about the effectiveness of monetary policy over the business cycle?

2. Derive the SRAS and LRAS curves from  labor supply-labor demand and production function diagrams (alternatively, do it mathematically as we did in class).

3. Use AD-AS and IS-MP diagrams to examine the short-run and long-run effects of an increase in business confidence.

4. Use AD-AS and IS-MP diagrams to examine the short-run and long-run effects of the Fed tightening monetary policy.

5. Use AD-AS and IS-MP diagrams to examine the short-run and long-run effects of a temporary increase in the price of oil. How does the result differ if the change in the price of oil is permanent?

6. Use AD-AS and IS-MP diagrams to examine the short-run and long-run effects of an increase in the capital stock.

Lecture 13 on Tuesday 11/13/2012

Brief Outline of Topics Covered in Lecture 13

Chapter 22 Aggregate Demand and Supply Analysis [continued]

The Aggregate Supply Curve 

• LRAS curve
• SRAS curve
• Shifts in the LRAS curve
• Shifts in the SRAS curve
• Equilibrium of AS and AD
• SR and LR response to AD shocks
• SR and LR response to AS shocks

Chapter 22 - Appendix - The Phillips Curve and the SRAS Curve

The Phillips curve 

• The PC in the 1960's: A permanent tradeoff
• The Friedman-Phelps augmented PC
• The modern PC (adds supply shocks)
• The modern PC with Adaptive Expectations
• Okun's law and the SRAS

Video

Not yet available

Extra Reading:

I mentioned this tendency for people to overstate inflation in class:

Getting the Questions Right, by David Altig, Atlanta Fed: Among the plethora of post-election exit-poll results, the CNBC website highlights a particularly interesting response, linked from the mega-blog Instapundit with the title "Voters Worry More About Inflation Than You Think." The CNBC article itself, written by Allison Linn, describes the poll results in more detail:

It's no surprise that voters in Tuesday's presidential election identified the economy as the No. 1 issue in the campaign, far ahead of health care and the federal budget deficit.
But it was a surprise that so many voters identified rising prices as the biggest economic problem they face.

Linn notes something of a disconnect between this view and the facts on the ground:

...inflation has generally been running well under 2 percent, and Federal Reserve bankers repeatedly have said they feel comfortable that low inflation allows them to keep interest rates at rock-bottom levels.

Yet in an exit poll of more than 25,000 voters conducted by NBC News, 37 percent identified rising prices as the biggest problem facing people like them.

Unemployment was cited by 38 percent, only slightly more than the number who said inflation was their top economic concern. Taxes were named by 14 percent and the housing market was the top concern of 8 percent.

The policy stakes on understanding these responses are pretty high. In the end, the cost of inflation comes in the form of how it may distort behavior and the allocation of resources. So the expectation or perception of significant inflation is at least as pernicious as the measurement itself.

But what, exactly, does this concern about "inflation" actually reflect? Probably not what we think. Some time ago, my colleagues Mike Bryan and Guhan Venkatu (from the Cleveland Fed) made note of "The Curiously Different Inflation Perspectives of Men and Women." Their findings are pretty informative:

Over the past few years, the Federal Reserve Bank of Cleveland, with assistance from the Ohio State University, has studied household inflation perceptions and expectations using a monthly survey of approximately 500 Ohioans (the FRBC/OSU Inflation Psychology Survey). This survey, which records respondents' perceptions of price changes over the past 12 months as well as their expectations for price changes over the next 12 months, has uncovered a surprising result. The data indicate that the public's estimates and predictions of inflation are significantly and systematically related to the demographic characteristics of the respondents. People with high incomes perceive and anticipate much less inflation than people with low incomes, married people less than singles, whites less than nonwhites, and middle-aged people less than young people. This Commentary describes what is perhaps the most curious observation of all: Even after we hold constant income, age, education, race, and marital status, men and women hold very different views on the rate at which prices are changing.

...[S]tatistical tests reveal that even after we adjust for the respondents' age, race, education, and income, women in our survey tended to think inflation was 1.9 percentage points higher than men. A similar examination of respondents' predictions of future inflation yields the same basic result: After we account for other major demographic factors, on average, women expected prices to rise 2.1 percentage points more than men.

It is important to note that this result was not unique to the Cleveland Fed study:

An examination of survey data collected by the University of Michigan (which has recorded the inflation forecasts of U.S. households on a monthly basis since 1978) reveals that women consistently hold higher inflation expectations than men, even after we hold constant other important demographic characteristics of the respondent.

Most intriguing of all, the systematic overstatement of inflation by all consumers, relative to official statistics, and the difference in responses between men and women are not a result of ignorance about the facts, according to those official statistics:

In the August 2001 FRBC/OSU survey, we sought an answer to this question by asking, "Have you heard of the Consumer Price Index (CPI) before?" and "By about what percentage do you think the CPI went up (or down), on average, over the last 12 months?"

A significantly higher proportion of men had heard of the CPI compared to women (75 percent versus 61 percent, respectively). For those who had heard of the CPI, the average perception about how much it had risen over the past 12 months was surprisingly accurate—a perceived increase of 2.9 percent compared to an actual increase of 2.7 percent. It is also very interesting that men and women perceived the CPI's growth rate nearly identically (2.8 percent versus 3.1 percent, respectively.) However, of those who knew of the CPI, the average perception of price increases was 6.7 percent. And even within the subgroup of respondents who knew of the CPI, men had a significantly lower perception of price increases than did women (6.0 percent vs. 7.4 percent). In other words, the public believes that prices are rising more than the CPI reports, and women more so than men.

There are a couple of hypotheses that could be advanced to explain results like this. One is that the conspiracy crowd is correct and the official statistics are rigged and vastly understate true inflation. But that wouldn't get us anywhere near an understanding of why survey responses about inflation would be systematically different across men and women, higher- and low- income individuals, and just about any other demographic cuts we might make.

A second possibility it is that individuals' responses reflect price changes in their own personal market basket, which may differ from that of the average urban wage earner whose habits are reflected in the Consumer Price Index (CPI).That might explain why any demographic sub group could arrive at different inflation perceptions, but it doesn't explain why respondents as a whole systematically overstate inflation relative to the CPI.

I think the most likely explanation is that the survey respondents are expressing a much different concern than whether they believe food, gas, autos, banking services, or whatever are increasing or are likely to increase faster than the official statistics indicate. My guess is that they are telling us that they are concerned that their real—or inflation-adjusted—incomes are not rising fast enough to comfortably sustain their desired spending:

(enlarge)

As I noted, the policy stakes are high. In the current environment, the policy prescription for fighting an incipient rise in inflation expectations would be much different than one deployed to address the reality of the chart above. All the more reason to make sure we understand the questions we are asking and the responses we get back.

Just to be sure, we monitor inflation trends and inflation expectations from a number of perspectives: Treasury Inflation Protected Securities (TIPS), forecasts, and the Business Inflation Expectations (BIE) survey, to name just three. And all are available on the Atlanta Fed's Inflation Project for the terminally curious to monitor with us.

Lecture 12 on Thursday 11/8/2012

Brief Outline of Topics Covered in Lecture 12

Chapter 22 Aggregate Demand and Supply Analysis

The Aggregate Supply Curve 

• LRAS curve
• SRAS curve
• Shifts in the LRAS curve
• Shifts in the SRAS curve
• Equilibrium of AS and AD
• SR and LR response to AD shocks
• SR and LR response to AS shocks

Video

Extra Reading:

About those jobless recoveries:

Jobless recoveries and the disappearance of routine occupations, by Henry Siu and Nir Jaimovich, Vox EU: Economic recoveries aren’t what they used to be. Since the end of the Great Recession in June 2009:

• US real GDP per capita grew by 3.6%,
• but per capita employment fell by 1.8% over and above the 5.5% that was lost during the recession.

This malaise in the US labor market has been the subject of countless economic policy debates. The fact that employment is recovering much slower than GDP is a relatively new phenomenon; jobless recoveries have only really occurred after the recessions of 1991 and 2001. These last three recoveries represent a distinct break from previous postwar episodes of recession when both GDP and employment would vigorously rebound following recessions (Schreft and Singh 2003; Groshen and Potter 2003; Bernanke 2009).

Our current research indicates that a jobless recovery is not simply an ‘economy-wide‘ delay in firms hiring again. Instead, it can be traced to a lack of recovery in a subset of occupations; those that focus on “routine” or repetitive tasks that are increasingly being performed by machines (Jaimovich and Siu 2012).

Job polarization

The fact that employment in routine occupations has been disappearing is well documented by recent job polarization literature (Acemoglu 1999, Autor et al. 2006, Goos and Manning 2007, Goos et al. 2009, Autor and Dorn 2012). This literature finds that occupations focused on routine tasks tend to be middle-waged. Thus, the disappearance of routine occupations in the past 30 years represents a ‘polarization’ of employment because the middle of the wage distribution has been hollowed out.

As recently as the mid-1980s, about one in three Americans over the age of 16 was employed in a routine occupation. Currently, that figure stands at one in four. The fact that polarization is occurring should not surprise anyone who understands the influence of robotics and automation on machinists and machine operators in manufacturing. Indeed, the influence of robotics is increasingly being felt on routine occupations in transportation and warehousing. Of equal importance is the disappearance of routine employment in ‘white-collar’ occupations - think bank tellers being replaced by ATMs, or secretarial work being replaced by personal computers and Siri, Apple’s iPhone-integrated ‘intelligent personal assistant’. Thus, all of the per capita employment growth of the past 30 years has either been in ‘non-routine’ occupations located at the high-end of the wage distribution, such as software engineers and economists, or in low-paying jobs, such as service occupations like restaurant waiters and janitors. For this last set of occupations, this has been especially true in the past decade.

Jobless recoveries

What is surprising is the link between job polarization and the business cycle. Figure 1 highlights our simple point; it plots per capita employment in routine occupations (in log levels) from 1967 to the end of 2011. Since about 1990, there is an obvious 28 log point decline in routine employment. What is equally clear is that this fall has not happened gradually over time but that the decline is concentrated in economic downturns. 92% of the 28 log point fall occurred within a 12 month window of NBER-dated recessions.

Figure 1

Following each of the 1991, 2001, and 2009 recessions, per capita employment in routine occupations fell and never recovered. This lack of recovery in routine employment accounts for the jobless recoveries experienced in the aggregate. Indeed, prior to job polarization, routine job losses in recessions were accompanied by strong routine job recoveries. This is evidenced in Figure 1 after the recessions of 1970, 1975, and 1982. Unsurprisingly, prior to job polarization, jobless recoveries did not occur. Moreover, jobless recoveries cannot be traced to the business cycle behavior of ‘non-routine’ jobs: employment in these occupations experience only mild contractions, if at all, during recessions, and have experienced essentially no change in the nature of their recoveries over the past half century.

Explaining jobless recovery

A simple counterfactual experiment clarifies the link between job polarization and jobless recoveries. Specifically, we ask what the recoveries in aggregate employment would have looked like if routine employment had rebounded as it did prior to job polarization. Would the US economy still have experienced jobless recoveries? For the 1991, 2001, and 2009 recessions, we replace the per capita employment in routine occupations (following the trough) with the average recoveries following the 1970, 1975, and 1982 recessions. We then sum up the actual employment in non-routine occupations with the counterfactual employment in routine occupations to obtain a counterfactual aggregate employment series.

The behavior of these counterfactual series around the recent NBER recessions is displayed in Figures 2a to 2c. The solid blue line indicates the time path of actual per capita employment. Date 0 indicates the month in which the NBER officially declared the end of the recession. As is clear, aggregate employment continued to fall for many months following the end of each recession. Note that the hatched red line represents the counterfactual series. Had employment in routine occupations recovered as it did prior to job polarization, the US economy would not have experienced jobless recoveries. Hence, we argue that jobless recoveries can be attributed to the lack of recovery in routine jobs.

Figure 2

Conclusions

Structural change in the labor market is clearly manifesting itself in the business cycle. The long-term decline in routine occupations is occurring in spurts - employment in these jobs is lost during recessions. The reach of job polarization is wide. Automation and the adoption of computing technology is leading to the decline of middle-wage jobs of many stripes, both blue-collar jobs in production and maintenance occupations and white-collar jobs in office and administrative support. It is affecting both male- and female-dominated professions and it is happening broadly across industries –manufacturing, wholesale and retail trade, financial services, and even public administration.

The loss of routine jobs in recent recessions has given rise to jobless recoveries. Aggregate employment struggles to rebound following recessions since middle-wage, routine occupations no longer recover. Moreover, employment growth following recent recessions has been unevenly distributed across pay, concentrated in high- and low-wage occupations. A recent report by the National Employment Law Project (2012) indicates that the recovery from the Great Recession has been particularly lopsided, with the majority of jobs added being low-paying jobs.

The pace of job polarization was greatly accelerated in this last recession, and the pace of automation and progress in robotics and computing technology is not slowing down either (Brynjolfsson and McAfee 2011). If the past 30 years is any guide, we should expect future recessions to continue to spur job polarization. Jobless recoveries may be the new norm.

References

Acemoglu, D (1999), “Changes in unemployment and wage inequality: An alternative theory and some evidence”, American Economic Review, 89(5), 1259–1278.

Autor, D H and D Dorn (2012), “The growth of low skill service jobs and the polarization of the U.S. labor market”, American Economic Review, forthcoming.

Autor, D H, L F Katz, and M S Kearney (2006), “The polarization of the U.S. labor market”, American Economic Review: Papers & Proceedings, 96(2), 189–194.

Bernanke, B S (2009), “On the outlook for the economy and policy”, Speech at the Economic Club of New York, 16 November.

Brynjolfsson, E and A McAfee (2011), Race Against The Machine: How the Digital Revolution is Accelerating Innovation, Driving Productivity, and Irreversibly Transforming Employment and the Economy, e-book, Digital Frontier Press.

Goos, M and A Manning (2007), “Lousy and lovely jobs: The rising polarization of work in Britain”, Review of Economics and Statistics, 89(1), 118–133.

Goos, M, A Manning, and A Salomons (2009), “Job polarization in Europe”, American Economic Review: Papers & Proceedings, 99(2), 58–63.

Groshen, E L and S Potter (2003), “Has structural change contributed to a jobless recovery?“, Current Issues in Economics and Finance, Federal Reserve Bank of New York , 9(8), 1–7.

Jaimovich, N and H E Siu (2012), “The trend is the cycle: job polarization and jobless recoveries”. NBER Working Paper, 18334.

National Employment Law Project (2012), “The low-wage recovery and growing inequality”, Data Brief, August.

Schreft, S L and A Singh (2003), “A closer look at jobless recoveries”, Economic Review, Federal Reserve Bank of Kansas City, Second Quarter, 45–72.

Lecture 11 on Tuesday 11/6/2012

Brief Outline of Topics Covered in Lecture 11

Chapter 21 The Monetary Policy and Aggregate Demand Curves

Policy effectiveness in the short-run

Chapter 22 Aggregate Demand and Supply Analysis

The Aggregate Supply Curve 

• LRAS curve
• SRAS curve
• Shifts in the LRAS curve
• Shifts in the SRAS curve
• Equilibrium of AS and AD
• SR and LR response to AD shocks
• SR and LR response to AS shocks

Video

Extra Reading:

How will the election change the Fed?, by Mark Thoma, CBS MoneyWatch: There is a lot of uncertainty about who will lead the Federal Reserve after current Chairman Ben Bernanke's term ends on Jan. 31, 2014. Although Bernanke is eligible to serve another four years, he has hinted that he may not seek another term. In addition, Republican presidential candidate Mitt Romney has made it clear that if he wins the election, he will appoint a new chairman whether or not Bernanke seeks another term.

If Bernanke is replaced, who is likely be the next Fed chief, and what impact will the change in leadership have on U.S. monetary policy?

If President Barack Obama is re-elected and chooses to replace Bernanke, I believe -- as do others -- that Fed Board of Governors Vice Chairman Janet Yellen is the most likely nominee. Her views are close to those of Bernanke, so she would provide the continuity that financial markets seek. She is also highly experienced, having served as president of the San Francisco Fed, and her academic credentials are very strong. She'll be able to handle the academic heavyweights on the bank's monetary policy committee. There are also political advantages for Obama if he appoints what would be the first female Fed chief.

If Romney is elected, it's a different story. Economists in the Romney camp, such as Stanford University's John Taylor, would be much more hawkish in trying to control inflation and much more devoted to following rule-based, rather than discretionary, policy.

Taylor, a favorite among many if Romney is elected, is responsible for the "Taylor Rule" as a guide to monetary policy. The Taylor rule links the interest rate set by the Fed to inflation and economic output so that interest rates rise when inflation goes up or the economy is booming, and fall when inflation is below target or the economy falls into a recession. He has been quite vocal in his opposition to any policy that deviates from this rule.

However, I don't think that Taylor is likely be the next Fed chair even if Romney wins, because the economist's hawkish views on monetary policy make him unlikely to survive Senate confirmation. I also don't think there's a strong favorite to point to if Taylor is out of the picture, though two other Romney economic advisers -- Columbia University's Glenn Hubbard and Greg Mankiw of Harvard University -- are often mentioned.

And in some ways, whomever is likely to get the nod in a Romney administration isn't that important, since that person is sure to have views that move policy in the direction that Taylor would favor.

But no matter who is in control of the Fed, in normal times policy is likely to be conducted much as the Taylor rule describes -- that was certainly true before the Great Recession. It's during abnormal times, as we've just experienced, when there is reason to abandon Taylor's approach and the differences in policy would emerge.

What would that mean for monetary policy? A Fed led by Taylor or someone with his views would be much less likely to react aggressively during a downturn or to implement bank bailouts, and much more likely to pursue a fast exit from any stimulative policies. For example, if Taylor had his way, the Fed already would have raised interest rates by now and would be backing off quantitative easing rather than implementing another round (if it ever pursued such a policy in the first place).

However, I don't want to overemphasize the differences even during unusual economic times. It's easy to criticize the Fed from the outside, and to proclaim that central bankers should stand up to the pressure not to bailout a troubled financial system. But when you are the Fed chair and it's your reputation on the line -- when people's livelihoods depend on your decisions, when the choice is between letting big banks fail and risking a complete blowout of the financial system -- or taking action known to stabilize the financial system, even hawkish chairs are likely to act.

After all, the bank bailout, though widely attributed to Obama, actually came under George W. Bush's presidency and was enacted with Republican support. If another financial meltdown happens, Fed action is likely no matter how much tough talk there's been in the past.

There's another reason to expect current policy to continue, at least initially, even if Fed leadership changes. The Fed chair, though very powerful, must still command a majority of votes on the bank's monetary policy committee in order to control policy. If the Fed chair proposes a radical departure from present policy, it is unlikely to be approved. Over time, as current Fed members' terms expire or they voluntarily step down, a president can shape the committee and policy through new appointment. But a new Fed chief would have a lot of trouble completely altering the course of policy on day one.

Of course, who wins the presidential election still matters. It shapes how aggressive and persistent monetary policy will be in combating unemployment, particularly during a severe recession. It also matters for another critical aspect of policy -- bank regulation. A Fed chair appointed by Obama would be much more likely to pursue strict regulation of banks than a Fed led by a Romney appointee. For those who believe that our current troubles are due, at least in part, to the failure to regulate the banking system, this is no small difference.

Homework 5

Economics 470/570
Fall 2012
Homework 5
Answers posted late Friday (11/9)

Chapter 20, pgs. 512-514

Problems 9, 11, 14, 24, and 25

Chapter 21, pgs. 525-527

Problems 11, 13, 22, and 24

Midterm Solution

Here's the midterm and the solution.

Lecture 10 on Thursday 11/1/2012

Brief Outline of Topics Covered in Lecture 10

Chapter 21 The Monetary Policy and Aggregate Demand Curves

The MP Curve 

• Shifts in the MP curve
• Slope of the MP curve

The Aggregate Demand Curve

• Shifts in the AD curve

Chapter 22 Aggregate Demand and Supply Analysis

The Aggregate Supply Curve 

• LRAS curve
• SRAS curve
• Shifts in the LRAS curve
• Shifts in the SRAS curve
• Equilibrium of AS and AD
• SR and LR response to AD shocks
• SR and LR response to AS shocks

Video

Extra Reading:

This is from the SF Fed:

Credit Access Following a Mortgage Default, by William Hedberg and John Krainer, FRBSF Economic Letter: Borrowers who default on mortgages return to the mortgage market at extremely slow rates. Only about 10% of borrowers with a prior serious delinquency regain access to the mortgage market within 10 years of their default. Borrowers who terminate mortgages for reasons other than default return to the market about two-and-a-half times faster than those who default. Renewed access to credit takes even longer for subprime borrowers with a serious delinquency on their record. [more here]

And, one more, UCSD economist Jim Hamilton on the economic damage from hurricane Sandy:

... One parallel to consider is the devastation from Hurricane Katrina in 2005. In addition to the short-run dislocations, this ended up causing lasting damage to offshore oil-producing infrastructure. An optimist might have thought this would create all kinds of new jobs trying to rebuild. The actual experience was not so cheerful.

Seasonally adjusted nonfarm employment in Louisiana, 2004:M1 - 2007:M12, in thousands of workers. Vertical line marks Hurricane Katrina in August 2005. Data source: BLS.

The Wall Street Journal reports that IHS estimates that Hurricane Sandy could reduce the 2012:Q4 U.S. real GDP growth rate by 0.6 percentage points at an annual rate. I'm not sure how one comes up with that kind of number. But I am persuaded this was not a good thing for the U.S. economy.

Lecture 9 on Tuesday 10/30/2012

Brief Outline of Topics Covered in Lecture 9

Chapter 20 The IS Curve

The IS curve

• Investment and the interest rate
• Net exports and the interest rate
• Equilibrium in the godds market
• The IS curve graphically, mathematically, and intuitively
• Shifts in the IS curve
• Slope of the IS curve

Chapter 21 The Monetary Policy and Aggregate Demand Curves

The MP Curve 

• Shifts in the MP curve
• Slope of the MP Curve

Video

Extra Reading:

From the Dallas Fed:

Behind the Numbers: PCE Inflation Update, September 2012: This update, prepared by Dallas Fed Senior Economist Jim Dolmas, provides an in-depth analysis of the latest personal consumption expenditures (PCE) inflation data. Updates will be posted monthly, following the release of the official PCE data by the Bureau of Economic Analysis. NOTE: Terms in bold are defined in the Inflation Update Glossary.

The Dallas Fed’s trimmed mean PCE inflation rate for September was an annualized 1.9 percent, up from a revised 1.7 percent in August. With the revision to August (originally reported as an annualized 2.0 percent rate), and the latest reading, the trimmed mean has now recorded six straight months of rates below annualized 2.0 percent, though just barely in September.

The six-month trimmed mean rate ticked down to an annualized 1.6 percent from 1.7 percent in August. The 12-month trimmed mean rate held steady at 1.8 percent for a third month in a row. As we’ve noted before, the current 12-month trimmed mean rate is a good forecast of average headline PCE inflation over the next 12 months—so we expect the headline rate to average 1.8 percent between now and September 2013.

For now, though, the headline PCE inflation rate continues to be buffeted by movements in energy prices, especially the price of gasoline. For a second month in a row, the headline price index increased at a roughly 5 percent annualized rate (5.0 percent in August and 4.7 percent in September), with increases in the price of gasoline being the main contributor.

Of course, these gasoline-fueled gains in the headline index follow several months of the opposite pattern—low headline rates, pulled down by declines in the price of gasoline. Consequently, average headline rates over several months remain moderate—the six-month headline rate was an annualized 1.5 percent in September while the 12-month headline rate came in at 1.7 percent. Both of these rates are up a bit from their August levels (annualized 1.2 percent for the six-month rate and 1.5 percent for the 12-month rate).

Note that at 1.7 percent, the current 12-month headline rate is not far from the 1.8 percent rate we would forecast (based on the trimmed mean) for the coming 12 months, so—in effect—we’re expecting very little change in headline PCE inflation. ...

Lecture 8 on Tuesday 10/23/2012

Brief Outline of Topics Covered in Lecture 8

Chapter 19 Money Demand [continued]

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

Chapter 20 The IS Curve

The IS curve

• Investment and the interest rate
• Net exports and the interest rate

Video

Extra Reading:

Milton Friedman's "plucking model" is an interesting alternative to the natural rate of output view of the world. The typical view of business cycles is one where the economy varies around a trend value (the trend can vary over time also). Milton Friedman has a different story. In Friedman's model, output moves along a ceiling value, the full employment value, and is occasionally plucked downward through a negative demand shock. Quoting from the article below:

In 1964, Milton Friedman first suggested his “plucking model” (reprinted in 1969; revisited in 1993) as an asymmetric alternative to the self-generating, symmetric cyclical process often used to explain contractions and subsequent revivals. Friedman describes the plucking model of output as a string attached to a tilted, irregular board. When the string follows along the board it is at the ceiling of maximum feasible output, but the string is occasionally plucked down by a cyclical contraction.

Friedman found evidence for the Plucking Model of aggregate fluctuations in a 1993 paper in Economic Inquiry. One reason I've always liked this paper is that Friedman first wrote it in 1964. He then waited for almost twenty years for new data to arrive and retested his model using only the new data. In macroeconomics, we often encounter a problem in testing theoretical models. We know what the data look like and what facts need to be explained by our models. Is it sensible to build a model to fit the data and then use that data to test it to see if it fits? Of course the model will fit the data, it was built to do so. Friedman avoided that problem since he had no way of knowing if the next twenty years of data would fit the model or not. It did. I was at an SF Fed Conference when he gave the 1993 paper and it was a fun and convincing presentation.

Let me try, within my limited artistic ability, to illustrate further. If you haven't seen a plucking model, here's a graph to illustrate (see Piger and Morley and Kim and Nelson for evidence supporting the plucking model and figures illustrating the plucking and natural rate characterizations of the data). The "plucks" are the deviations of the red line from blue line representing the ceiling/trend:

Notice that the size of the downturn from the ceiling from  a→b (due to the "pluck") is predictive of the size of the upturn from b→c that follows taking account of the slope of the trend. I didn't show it, but in this model the size of the boom, the movement from b→c, does not predict the size of the subsequent contraction. This is the evidence that Friedman originally used to support the plucking model. In a natural rate model, there is no reason to expect such a correlation. Here's an example natural rate model:

Here, the size of the downturn a→b does not predict the size of the subsequent boom b→c. Friedman found the size of a→b predicts b→c supporting the plucking model over the natural rate model.

Homework 4

Economics 470/570
Fall 2012
Homework #4
Answers posted late Tuesday (10/23)

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.

[Update: We didn't get to problem 4, so omit this problem]

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

Lecture 7 on Thursday 10/18/2012

Brief Outline of Topics Covered in Lecture 7

Chapter 15 Tools of Monetary Policy [continued]

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 [we're unlikely to get all the way through this chapter]

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

Extra Reading:

Tim Duy:

Buyer's Remorse?, by Tim Duy: Unavoidable work obligations took priority over blogging during the past week. Of course, blogging or not, the data flow continues uninterrupted. And the tenor of that data has been generally positive. In the near-term, the upbeat news will have limited impact on monetary policy. The Fed will remain committed to the path laid out at the last FOMC meeting. That said, I have to imagine some of the moderates on the FOMC - those pulled into Federal Reserve Chairman Ben Bernanke's gravity with the softening of data this summer - will be starting to feel a little bit of buyer's remorse, thinking that maybe, just maybe, they pulled the trigger a little too soon. The doves, of course, should be ecstatic that the FOMC locked in an easier policy at beginning of an upswing. Rather than threatening to withdraw stimulus at the slightest sign of recovery, now we have a commitment to keep monetary momentum until the economy is clearly on firmer ground. This will be supportive of the upswing in activity.

The death of the consumer continues to be more myth than reality. The retail sales report revealed that households have shaken off the summer doldrums:

While the year over year trend is not particularly strong:

the last three months have packed a bit of a punch:

While industrial production was up somewhat, the trend over the past year is basically flat:

The underlying story, I think, remains two-fold. First, some investment was likely pulled forward into 2011 by now-expired tax credits. Second, the global slowdown is also weighing on manufacturing growth. That said, note that the current scenario continues to look more like 1998 than 2008:

To be sure, core new orders have been a little unnerving of late, and certainly something to watch. But this would not be the first time that an external shock failed to deliver a US recession. For now, I expect that to continue to be the case.

And one reason to believe that the US will escape recession is the obviously improving housing market. Starts exceeded expectations in September:

And while the gains in multi-family relative to past trends look more pronounced, single-family homes are trending up as well:

Can we attribute September's strength to QE3? I think it is somewhat of a stretch to believe that builders were sitting around waiting for the go-ahead from the Fed; this is especially true of multi-family housing, a category that requires a bit of lead time before shovels break earth. Still, I think that you can argue that the build-up to QE3 supported expectations that monetary policy would tend toward easier rather than tighter, reducing uncertainty that the Fed would pull the plug just as new projects were taking off.

What else can we say about housing? The Wall Street Journal offered up three views of the data. First:

This move forward from the bottom was inevitable, says Patrick Newport of IHS Global Insight. “Housing has a self-correcting mechanism — it’s called population growth. Every year, the U.S. population increases by about 3 million, and the number of households increases by 1.1-1.3 million. New homes have to be built to meet demand from this segment. In recent years, housing construction has been depressed, first because of overbuilding during the boom years, then, because the Great Recession forced many Americans to move in with friends and family,” he said.

I agree; the long period of bouncing along the bottom was starting to look excessive. It couldn't last forever. Second:

But that correction doesn’t mean that housing is going to lead a broader recovery. “The sector is much less important than it used to be,” said economist Jim O’Sullivan atHigh Frequency Economics, Ltd. “Total residential investment directly accounts for 2.4% of GDP now, down from a 6.3% peak in 2005. Within that, new home construction, the part tracked by housing starts, accounts for 0.9% of GDP now, vs. a peak of 3.9% in 2005.”

True, housing is a relatively small part of the economy. And I can argue that the emphasis on multi-family units will be yield less of an economic boost compared to single-family housing. Moreover, I have yet to be convinced that we are on the verge of another price bubble that will swell net worth and trigger a jump in mortgage equity withdrawal. But, even an additional 0.5 percentage point contribution from residential housing is meaningful when the economy is bouncing along at 2% growth. I am not expecting miracles, but a recovering housing sector is certainly a step in the right direction. Finally, we have this:

The housing recovery has materialized, but the strength of that recovery is an open question. “How far can the rebound go with unemployment where it is? From our perspective, not much farther,” said economist Steve Blitz at ITG Investment Research, Inc. “The notion housing will now lead rather than reflect the overall economy is a bit too optimistic. The demographics lean against a national boom in home construction as does the limited availability of mortgage credit.”

Traditionally, housing has led the economy. I wouldn't bet against it. Moreover, this analysis appears to assume that unemployment rates stay constant, which seems like something of a heroic assumption given the steady decline in the unemployment rate experienced over the last three years:

Moreover, mortgage credit will loosen up as the housing recovery broadens and deepens. Lender confidence will improve as prices stabilize. Ultimately, they want to lend money; it's how they make more money.

I am not sure that the FOMC would have moved on QE3 if the data then was what we are seeing now. If this data flow continuous - a big "if" considering the propensity of the data to swing from optimistic to pessimistic throughout the course of the year - some moderates will likely question their decision. But the die has been cast, and will not be shattered easily. New York Federal Reserve President William Dudley reminds us:

Even over the next few years, while there are significant downside risks relating to the fiscal cliff and the eurozone, it is possible that the recovery could turn out stronger than expected. The underlying process of balance sheet repair is considerably advanced, housing is recovering and, as that occurs, our newly recalibrated monetary policy could gain additional traction. Thus, if uncertainties about the U.S. fiscal path and the future of the eurozone were resolved in a constructive manner, growth could pick up more vigorously than anticipated.

This would be a wonderful outcome. The September FOMC statement noted: the Committee expects "that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the recovery strengthens". Consistent with this, if we were to see some good news on growth I would not expect us to respond in a hasty manner. Only as we became confident that the recovery was securely established, would I expect our monetary policy stance to evolve to ensure that it remained appropriate to achievement of our objective: maximum sustainable employment in the context of price stability.

For now, price stability is on the side of the Federal Reserve, allowing for policymakers to keep pressure on the gas pedal despite improving data. While the headline CPI jumped 0.6%, core gained just 0.1% in September, suggesting that the headline gains remain a transitory artifact of higher gas prices. The year-over-year trends are not worrisome:

Remember that CPI inflation tends to run a bit above the Fed's PCE target. Moreover, note that wage growth remains constrained, limiting the ability of inflationary pressures to spread. The recovery has room to run before we see sufficient pressure on wage growth to raise the specter of tighter policy. Note that the Fed's commitment to supportive policy stands in stark contrast to their almost eager desire to shift to tighter policy after previous upswings in activity. In short, Fed policy is ramping up in line with the housing market and the broader economy, hopefully providing the boost that is capable of breaking the economy free of the zero bound. This bodes well for growth in 2013.

That is, unless Congress lets the economy fall off the fiscal cliff. No, nothing is written in stone at the moment. Plenty of things can go wrong with fiscal policy, Europe, war in the Middle East, etc. The usual suspects. But for now these are risks, not reality. I think the reality is that the economy looks a little brighter than just three months ago.

Bottom Line: I fear becoming too optimistic. During the recovery, excessive optimism has tend to result in disappointment. A month of data, after all, is just a month of data. At the same time, however, the pessimistic story is fading further into the distance. So far that some monetary policymakers might be having second thoughts about QE3. But even if they have such thoughts, and even if the hawks start chirping louder, the Fed is now committed to this path. Assuming inflation remains contained, at this point I suspect that we would need to see sustainable growth well above 3 percent in 2013 (the Fed's central forecast is 2.5-3%) before policymakers are willing to consider pulling their foot off the gas anytime soon.

Lecture 6 on Tuesday 10/16/2012

Brief Outline of Topics Covered in Lecture 6

Chapter 14 Structure of Central Banks and the Federal Reserve System [continued]

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
• Currency and Deposits

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

Video

Extra Reading:

The Recovery and Monetary Policy, William C. Dudley, President and Chief Executive Officer, NY Fed: Good morning. It is a pleasure to have the opportunity to speak at this NABE (National Association for Business Economics) conference today. Having spent more than 20 years as a business economist working in the private sector before joining the Federal Reserve Bank of New York in 2007, I feel right at home here today.

My remarks will focus on the economic outlook. I do this with some trepidation, of course. In the private sector there are two adages about forecasting that underscore the need to be humble in this endeavor: First, forecast often. Second, specify a level or a time horizon, but never specify both, together.

But more seriously, despite the difficulties in making accurate forecasts, we still need to understand as best we can why the economy is performing the way it is, what that implies about the economic outlook, and, how policymakers can respond to generate better outcomes. We live in a highly complex and uncertain world, but we need to make as much sense out of it as possible. As always, what I have to say reflects my own views and not necessarily those of the FOMC (Federal Open Market Committee) or the Federal Reserve System.

My attention today will be on three important questions:

Why has the U.S. recovery been so sluggish and consistently weaker than expected?   What should we, as monetary policymakers, do it about it? What other policy actions are needed to help ensure a timely transition to strong and sustainable growth?

Homework 3

Homework 3
Answers posted 10/19

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

2. 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.

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

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

5. 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.

6. 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.

7. Show how the Fed's operating procedure limits the variability in the federal funds rate.

Lecture 5 on Tuesday 10/9/2012

Brief Outline of Topics Covered in Lecture 5

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

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

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
• Currency and Deposits

Chapter 15 Tools of Monetary Policy [probably won't get this far]

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

Video

Extra Reading:

Preliminary evidence from Brent Meyer and Guhan Venkatu of the Cleveland Fed shows that the median CPI is a robust measure of underlying inflation trends:

Trimmed-Mean Inflation Statistics: Just Hit the One in the Middle Brent Meyer and Guhan Venkatu: This paper reinvestigates the performance of trimmed-mean inflation measures some 20 years since their inception, asking whether there is a particular trimmed-mean measure that dominates the median CPI. Unlike previous research, we evaluate the performance of symmetric and asymmetric trimmed-means using a well-known equality of prediction test. We find that there is a large swath of trimmed-means that have statistically indistinguishable performance. Also, while the swath of statistically similar trims changes slightly over different sample periods, it always includes the median CPI—an extreme trim that holds conceptual and computational advantages. We conclude with a simple forecasting exercise that highlights the advantage of the median CPI relative to other standard inflation measures.

In the introduction, they add:

In general, we find aggressive trimming (close to the median) that is not too asymmetric appears to deliver the best forecasts over the time periods we examine. However, these “optimal” trims vary slightly across periods and are never statistically superior to the median CPI. Given that the median CPI is conceptually easy for the public to understand and is easier to reproduce, we conclude that it is arguably a more useful measure of underlying inflation for forecasters and policymakers alike.

And they conclude the paper with:

While we originally set out to find a single superior trimmed-mean measure, we could not conclude as such. In fact, it appears that a large swath of candidate trims hold statistically indistinguishable forecasting ability. That said, in general, the best performing trims over a variety of time periods appear to be somewhat aggressive and almost always include symmetric trims. Of this set, the median CPI stands out, not for any superior forecasting performance, but because of its conceptual and computational simplicity—when in doubt, hit the one in the middle.

Interestingly, and contrary to Dolmas (2005) we were unable to find any convincing evidence that would lead us to choose an asymmetric trim. While his results are based on components of the PCE chain-price index, a large part (roughly 75% of the initial release) of the components comprising the PCE price index are directly imported from the CPI. It could be the case that the imputed PCE components are creating the discrepancy. The trimmed-mean PCE series currently produced by the Federal Reserve Bank of Dallas trims 24 percent from the lower tail and 31 percent from the upper tail of the PCE price-change distribution. This particular trim is relatively aggressive and is not overly asymmetric—two features consistent with the best performing trims in our tests.

Finally, even though we failed to best the median CPI in our first set of tests, it remains the case that the median CPI is generally a better forecaster of future inflation over policy-relevant time horizons (i.e. inflation over the next 2-3 years) than the headline and core CPI.

I'll say more to say about this in class.

Homework 2

Homework 2
Answers posted 10/11

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. Who is on the FOMC? What does the FOMC do?

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

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

Lecture 4 on Thursday 10/4/2012

Brief Outline of Topics Covered in Lecture 4

Chapter 13 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 14 Multiple Deposit Creation and the Money Supply Process [unlikely we'll get this far]

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

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
• Currency and Deposits

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.

Extra Reading:

The Minutes from the last FOMC meeting will be released today, so I thought this was appropriate:

How the Fed Prepares Its Minutes, by Kristina Peterson, WSJ: Minutes for Federal Open Market Committee meetings are prepared with meticulous care. Central bank officials and staff know that the public will scrutinize every word and the minutes are carefully crafted to convey a certain message.

The process commences even before the meeting begins with a Board of Governors staffer writing up a summary of the staff’s economic and financial analyses, which are delivered at the start of each meeting.

Several senior staff members collaborate to plan the write-up of the meaty part of the meeting: the Fed officials’ policy negotiations. They discuss the meeting’s “major themes” and how they should be covered in the minutes, according to an article in the spring 2005 issue of the Federal Reserve Bulletin.

One officer from the Board’s Division of Monetary Affairs, chosen on a rotating basis, writes up the policy discussion, in part relying on a transcript that is ready by the day after the meeting. Other staff members review the summary before sending it to Fed officials during the week following the meeting.

The Fed’s chairman is the first policy maker to review the minutes. After receiving the Fed chief’s approval, the minutes are sent to all meeting participants for comments and a revised draft is prepared by the following week.

The final draft is ready by the end of the second week. The Fed officials who can vote on interest-rate moves–the seven-person Board of Governors and five of the 12 regional bank presidents–have about four calendar days to vote to approve the minutes. The voting period ends at noon the day before the minutes are released, 21 days after the meeting.

The Fed decided to start releasing minutes three weeks after policy meetings in late 2004. Before that, the minutes were released with a longer lag. In its earliest days, the Fed kept its minutes confidential and only released a “Record of Policy Actions” once a year. Over time, the Fed decided to release more information on a more-frequent basis.

The central bank now releases full transcripts of meetings with a five-year lag.

Additional Reading: Come With Me to the FOMC

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.

...“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, but with a few grains of salt.

I once committed political incorrectness by not treating them respectfully enough. It was sometime during the boom of the late 1990s that I observed out loud that the staff’s growth forecast was usually a percentage point too low and that its inflation forecast was usually a percentage point too high. I announced that I derived my own forecast by moving that one percent from inflation to growth. The obvious truth of my statement only made it worse and added to the coolness of the breeze that came my way for some time after that.

The forecasts of high inflation, while actual inflation remained low, were the cause of my lone dissents in June and August 1999 against raising the target federal funds rate. Actual inflation was nil, but the models always had it right around the corner.

I probably made things worse by saying in speeches that my favorite economists were Yogi Berra and Richard Pryor: Yogi, for saying you can observe a lot just by watching, and Richard for famously asking, “Who are you going to believe — me or your own lying eyes?” Sometimes, I would also paraphrase Mae West and say “too much of a good thing is just about right,” referring, of course, to the booming economy.

These days, I’ll bet F.O.M.C. members really can’t believe their own lying eyes.

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

Lecture 3 on Tuesday 10/2/2012

Brief Outline of Topics Covered in Lecture 3

Chapter 3 What is Money? [continued]

Measuring Money

The Federal Reserve’s Monetary Aggregates

How Reliable Are Money Data?

Chapter 4 Understanding Interest Rates [pages 81-84]

The Distinction between Real and Nominal Interest Rates

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

Chapter 13 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

Chapter 13 Multiple Deposit Creation and the Money Supply Process [unlikely we'll get this far]

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:

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

Decision Making within the Federal Reserve System

Extra Reading: Ben Bernanke: Five Questions about the Federal Reserve and Monetary Policy

Five Questions about the Federal Reserve and Monetary Policy, Speech, Chairman Ben S. Bernanke, At the Economic Club of Indiana, Indianapolis, Indiana, October 1, 2012: Good afternoon. I am pleased to be able to join the Economic Club of Indiana for lunch today. I note that the mission of the club is "to promote an interest in, and enlighten its membership on, important governmental, economic and social issues." I hope my remarks today will meet that standard. Before diving in, I'd like to thank my former colleague at the White House, Al Hubbard, for helping to make this event possible. As the head of the National Economic Council under President Bush, Al had the difficult task of making sure that diverse perspectives on economic policy issues were given a fair hearing before recommendations went to the President. Al had to be a combination of economist, political guru, diplomat, and traffic cop, and he handled it with great skill.

My topic today is "Five Questions about the Federal Reserve and Monetary Policy." I have used a question-and-answer format in talks before, and I know from much experience that people are eager to know more about the Federal Reserve, what we do, and why we do it. And that interest is even broader than one might think. I'm a baseball fan, and I was excited to be invited to a recent batting practice of the playoff-bound Washington Nationals. I was introduced to one of the team's star players, but before I could press my questions on some fine points of baseball strategy, he asked, "So, what's the scoop on quantitative easing?" So, for that player, for club members and guests here today, and for anyone else curious about the Federal Reserve and monetary policy, I will ask and answer these five questions:

1. What are the Fed's objectives, and how is it trying to meet them?
2. What's the relationship between the Fed's monetary policy and the fiscal decisions of the Administration and the Congress?
3. What is the risk that the Fed's accommodative monetary policy will lead to inflation?
4. How does the Fed's monetary policy affect savers and investors?
5. How is the Federal Reserve held accountable in our democratic society?

What Are the Fed's Objectives, and How Is It Trying to Meet Them?
The first question on my list concerns the Federal Reserve's objectives and the tools it has to try to meet them.

As the nation's central bank, the Federal Reserve is charged with promoting a healthy economy--broadly speaking, an economy with low unemployment, low and stable inflation, and a financial system that meets the economy's needs for credit and other services and that is not itself a source of instability. We pursue these goals through a variety of means. Together with other federal supervisory agencies, we oversee banks and other financial institutions. We monitor the financial system as a whole for possible risks to its stability. We encourage financial and economic literacy, promote equal access to credit, and advance local economic development by working with communities, nonprofit organizations, and others around the country. We also provide some basic services to the financial sector--for example, by processing payments and distributing currency and coin to banks.

But today I want to focus on a role that is particularly identified with the Federal Reserve--the making of monetary policy. The goals of monetary policy--maximum employment and price stability--are given to us by the Congress. These goals mean, basically, that we would like to see as many Americans as possible who want jobs to have jobs, and that we aim to keep the rate of increase in consumer prices low and stable.

In normal circumstances, the Federal Reserve implements monetary policy through its influence on short-term interest rates, which in turn affect other interest rates and asset prices.¹ Generally, if economic weakness is the primary concern, the Fed acts to reduce interest rates, which supports the economy by inducing businesses to invest more in new capital goods and by leading households to spend more on houses, autos, and other goods and services. Likewise, if the economy is overheating, the Fed can raise interest rates to help cool total demand and constrain inflationary pressures.

Following this standard approach, the Fed cut short-term interest rates rapidly during the financial crisis, reducing them to nearly zero by the end of 2008--a time when the economy was contracting sharply. At that point, however, we faced a real challenge: Once at zero, the short-term interest rate could not be cut further, so our traditional policy tool for dealing with economic weakness was no longer available. Yet, with unemployment soaring, the economy and job market clearly needed more support. Central banks around the world found themselves in a similar predicament. We asked ourselves, "What do we do now?"

To answer this question, we could draw on the experience of Japan, where short-term interest rates have been near zero for many years, as well as a good deal of academic work. Unable to reduce short-term interest rates further, we looked instead for ways to influence longer-term interest rates, which remained well above zero. We reasoned that, as with traditional monetary policy, bringing down longer-term rates should support economic growth and employment by lowering the cost of borrowing to buy homes and cars or to finance capital investments. Since 2008, we've used two types of less-traditional monetary policy tools to bring down longer-term rates.

The first of these less-traditional tools involves the Fed purchasing longer-term securities on the open market--principally Treasury securities and mortgage-backed securities guaranteed by government-sponsored enterprises such as Fannie Mae and Freddie Mac. The Fed's purchases reduce the amount of longer-term securities held by investors and put downward pressure on the interest rates on those securities. That downward pressure transmits to a wide range of interest rates that individuals and businesses pay. For example, when the Fed first announced purchases of mortgage-backed securities in late 2008, 30-year mortgage interest rates averaged a little above 6percent; today they average about 3-1/2 percent. Lower mortgage rates are one reason for the improvement we have been seeing in the housing market, which in turn is benefiting the economy more broadly. Other important interest rates, such as corporate bond rates and rates on auto loans, have also come down. Lower interest rates also put upward pressure on the prices of assets, such as stocks and homes, providing further impetus to household and business spending.

The second monetary policy tool we have been using involves communicating our expectations for how long the short-term interest rate will remain exceptionally low. Because the yield on, say, a five-year security embeds market expectations for the course of short-term rates over the next five years, convincing investors that we will keep the short-term rate low for a longer time can help to pull down market-determined longer-term rates. In sum, the Fed's basic strategy for strengthening the economy--reducing interest rates and easing financial conditions more generally--is the same as it has always been. The difference is that, with the short-term interest rate nearly at zero, we have shifted to tools aimed at reducing longer-term interest rates more directly.

Last month, my colleagues and I used both tools--securities purchases and communications about our future actions--in a coordinated way to further support the recovery and the job market. Why did we act? Though the economy has been growing since mid-2009 and we expect it to continue to expand, it simply has not been growing fast enough recently to make significant progress in bringing down unemployment. At 8.1 percent, the unemployment rate is nearly unchanged since the beginning of the year and is well above normal levels. While unemployment has been stubbornly high, our economy has enjoyed broad price stability for some time, and we expect inflation to remain low for the foreseeable future. So the case seemed clear to most of my colleagues that we could do more to assist economic growth and the job market without compromising our goal of price stability.

Specifically, what did we do? On securities purchases, we announced that we would buy mortgage-backed securities guaranteed by the government-sponsored enterprises at a rate of $40 billion per month. Those purchases, along with the continuation of a previous program involving Treasury securities, mean we are buying $85 billion of longer-term securities per month through the end of the year. We expect these purchases to put further downward pressure on longer-term interest rates, including mortgage rates. To underline the Federal Reserve's commitment to fostering a sustainable economic recovery, we said that we would continue securities purchases and employ other policy tools until the outlook for the job market improves substantially in a context of price stability.

In the category of communications policy, we also extended our estimate of how long we expect to keep the short-term interest rate at exceptionally low levels to at least mid-2015. That doesn't mean that we expect the economy to be weak through 2015. Rather, our message was that, so long as price stability is preserved, we will take care not to raise rates prematurely. Specifically, we expect that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economy strengthens. We hope that, by clarifying our expectations about future policy, we can provide individuals, families, businesses, and financial markets greater confidence about the Federal Reserve's commitment to promoting a sustainable recovery and that, as a result, they will become more willing to invest, hire and spend.

Now, as I have said many times, monetary policy is no panacea. It can be used to support stronger economic growth in situations in which, as today, the economy is not making full use of its resources, and it can foster a healthier economy in the longer term by maintaining low and stable inflation. However, many other steps could be taken to strengthen our economy over time, such as putting the federal budget on a sustainable path, reforming the tax code, improving our educational system, supporting technological innovation, and expanding international trade. Although monetary policy cannot cure the economy's ills, particularly in today's challenging circumstances, we do think it can provide meaningful help. So we at the Federal Reserve are going to do what we can do and trust that others, in both the public and private sectors, will do what they can as well.

What's the Relationship between Monetary Policy and Fiscal Policy?
That brings me to the second question: What's the relationship between monetary policy and fiscal policy? To answer this question, it may help to begin with the more basic question of how monetary and fiscal policy differ.

In short, monetary policy and fiscal policy involve quite different sets of actors, decisions, and tools. Fiscal policy involves decisions about how much the government should spend, how much it should tax, and how much it should borrow. At the federal level, those decisions are made by the Administration and the Congress. Fiscal policy determines the size of the federal budget deficit, which is the difference between federal spending and revenues in a year. Borrowing to finance budget deficits increases the government's total outstanding debt.

As I have discussed, monetary policy is the responsibility of the Federal Reserve--or, more specifically, the Federal Open Market Committee, which includes members of the Federal Reserve's Board of Governors and presidents of Federal Reserve Banks. Unlike fiscal policy, monetary policy does not involve any taxation, transfer payments, or purchases of goods and services. Instead, as I mentioned, monetary policy mainly involves the purchase and sale of securities. The securities that the Fed purchases in the conduct of monetary policy are held in our portfolio and earn interest. The great bulk of these interest earnings is sent to the Treasury, thereby helping reduce the government deficit. In the past three years, the Fed remitted $200 billion to the federal government. Ultimately, the securities held by the Fed will mature or will be sold back into the market. So the odds are high that the purchase programs that the Fed has undertaken in support of the recovery will end up reducing, not increasing, the federal debt, both through the interest earnings we send the Treasury and because a stronger economy tends to lead to higher tax revenues and reduced government spending (on unemployment benefits, for example).

Even though our activities are likely to result in a lower national debt over the long term, I sometimes hear the complaint that the Federal Reserve is enabling bad fiscal policy by keeping interest rates very low and thereby making it cheaper for the federal government to borrow. I find this argument unpersuasive. The responsibility for fiscal policy lies squarely with the Administration and the Congress. At the Federal Reserve, we implement policy to promote maximum employment and price stability, as the law under which we operate requires. Using monetary policy to try to influence the political debate on the budget would be highly inappropriate. For what it's worth, I think the strategy would also likely be ineffective: Suppose, notwithstanding our legal mandate, the Federal Reserve were to raise interest rates for the purpose of making it more expensive for the government to borrow. Such an action would substantially increase the deficit, not only because of higher interest rates, but also because the weaker recovery that would result from premature monetary tightening would further widen the gap between spending and revenues. Would such a step lead to better fiscal outcomes? It seems likely that a significant widening of the deficit--which would make the needed fiscal actions even more difficult and painful--would worsen rather than improve the prospects for a comprehensive fiscal solution.

I certainly don't underestimate the challenges that fiscal policymakers face. They must find ways to put the federal budget on a sustainable path, but not so abruptly as to endanger the economic recovery in the near term. In particular, the Congress and the Administration will soon have to address the so-called fiscal cliff, a combination of sharply higher taxes and reduced spending that is set to happen at the beginning of the year. According to the Congressional Budget Office and virtually all other experts, if that were allowed to occur, it would likely throw the economy back into recession. The Congress and the Administration will also have to raise the debt ceiling to prevent the Treasury from defaulting on its obligations, an outcome that would have extremely negative consequences for the country for years to come. Achieving these fiscal goals would be even more difficult if monetary policy were not helping support the economic recovery.

What Is the Risk that the Federal Reserve's Monetary Policy Will Lead to Inflation?
A third question, and an important one, is whether the Federal Reserve's monetary policy will lead to higher inflation down the road. In response, I will start by pointing out that the Federal Reserve's price stability record is excellent, and we are fully committed to maintaining it. Inflation has averaged close to 2 percent per year for several decades, and that's about where it is today. In particular, the low interest rate policies the Fed has been following for about five years now have not led to increased inflation. Moreover, according to a variety of measures, the public's expectations of inflation over the long run remain quite stable within the range that they have been for many years.

With monetary policy being so accommodative now, though, it is not unreasonable to ask whether we are sowing the seeds of future inflation. A related question I sometimes hear--which bears also on the relationship between monetary and fiscal policy, is this: By buying securities, are you "monetizing the debt"--printing money for the government to use--and will that inevitably lead to higher inflation? No, that's not what is happening, and that will not happen. Monetizing the debt means using money creation as a permanent source of financing for government spending. In contrast, we are acquiring Treasury securities on the open market and only on a temporary basis, with the goal of supporting the economic recovery through lower interest rates. At the appropriate time, the Federal Reserve will gradually sell these securities or let them mature, as needed, to return its balance sheet to a more normal size. Moreover, the way the Fed finances its securities purchases is by creating reserves in the banking system. Increased bank reserves held at the Fed don't necessarily translate into more money or cash in circulation, and, indeed, broad measures of the supply of money have not grown especially quickly, on balance, over the past few years.

For controlling inflation, the key question is whether the Federal Reserve has the policy tools to tighten monetary conditions at the appropriate time so as to prevent the emergence of inflationary pressures down the road. I'm confident that we have the necessary tools to withdraw policy accommodation when needed, and that we can do so in a way that allows us to shrink our balance sheet in a deliberate and orderly way. For example, the Fed can tighten policy, even if our balance sheet remains large, by increasing the interest rate we pay banks on reserve balances they deposit at the Fed. Because banks will not lend at rates lower than what they can earn at the Fed, such an action should serve to raise rates and tighten credit conditions more generally, preventing any tendency toward overheating in the economy.

Of course, having effective tools is one thing; using them in a timely way, neither too early nor too late, is another. Determining precisely the right time to "take away the punch bowl" is always a challenge for central bankers, but that is true whether they are using traditional or nontraditional policy tools. I can assure you that my colleagues and I will carefully consider how best to foster both of our mandated objectives, maximum employment and price stability, when the time comes to make these decisions.

How Does the Fed's Monetary Policy Affect Savers and Investors?
The concern about possible inflation is a concern about the future. One concern in the here and now is about the effect of low interest rates on savers and investors. My colleagues and I know that people who rely on investments that pay a fixed interest rate, such as certificates of deposit, are receiving very low returns, a situation that has involved significant hardship for some.

However, I would encourage you to remember that the current low levels of interest rates, while in the first instance a reflection of the Federal Reserve's monetary policy, are in a larger sense the result of the recent financial crisis, the worst shock to this nation's financial system since the 1930s. Interest rates are low throughout the developed world, except in countries experiencing fiscal crises, as central banks and other policymakers try to cope with continuing financial strains and weak economic conditions.

A second observation is that savers often wear many economic hats. Many savers are also homeowners; indeed, a family's home may be its most important financial asset. Many savers are working, or would like to be. Some savers own businesses, and--through pension funds and 401(k) accounts--they often own stocks and other assets. The crisis and recession have led to very low interest rates, it is true, but these events have also destroyed jobs, hamstrung economic growth, and led to sharp declines in the values of many homes and businesses. What can be done to address all of these concerns simultaneously? The best and most comprehensive solution is to find ways to a stronger economy. Only a strong economy can create higher asset values and sustainably good returns for savers. And only a strong economy will allow people who need jobs to find them. Without a job, it is difficult to save for retirement or to buy a home or to pay for an education, irrespective of the current level of interest rates.

The way for the Fed to support a return to a strong economy is by maintaining monetary accommodation, which requires low interest rates for a time. If, in contrast, the Fed were to raise rates now, before the economic recovery is fully entrenched, house prices might resume declines, the values of businesses large and small would drop, and, critically, unemployment would likely start to rise again. Such outcomes would ultimately not be good for savers or anyone else.

How Is the Federal Reserve Held Accountable in a Democratic Society?
I will turn, finally, to the question of how the Federal Reserve is held accountable in a democratic society.

The Federal Reserve was created by the Congress, now almost a century ago. In the Federal Reserve Act and subsequent legislation, the Congress laid out the central bank's goals and powers, and the Fed is responsible to the Congress for meeting its mandated objectives, including fostering maximum employment and price stability. At the same time, the Congress wisely designed the Federal Reserve to be insulated from short-term political pressures. For example, members of the Federal Reserve Board are appointed to staggered, 14-year terms, with the result that some members may serve through several Administrations. Research and practical experience have established that freeing the central bank from short-term political pressures leads to better monetary policy because it allows policymakers to focus on what is best for the economy in the longer run, independently of near-term electoral or partisan concerns. All of the members of the Federal Open Market Committee take this principle very seriously and strive always to make monetary policy decisions based solely on factual evidence and careful analysis.

It is important to keep politics out of monetary policy decisions, but it is equally important, in a democracy, for those decisions--and, indeed, all of the Federal Reserve's decisions and actions--to be undertaken in a strong framework of accountability and transparency. The American people have a right to know how the Federal Reserve is carrying out its responsibilities and how we are using taxpayer resources.

One of my principal objectives as Chairman has been to make monetary policy at the Federal Reserve as transparent as possible. We promote policy transparency in many ways. For example, the Federal Open Market Committee explains the reasons for its policy decisions in a statement released after each regularly scheduled meeting, and three weeks later we publish minutes with a detailed summary of the meeting discussion. The Committee also publishes quarterly economic projections with information about where we anticipate both policy and the economy will be headed over the next several years. I hold news conferences four times a year and testify often before congressional committees, including twice-yearly appearances that are specifically designated for the purpose of my presenting a comprehensive monetary policy report to the Congress. My colleagues and I frequently deliver speeches, such as this one, in towns and cities across the country.

The Federal Reserve is also very open about its finances and operations. The Federal Reserve Act requires the Federal Reserve to report annually on its operations and to publish its balance sheet weekly. Similarly, under the financial reform law enacted after the financial crisis, we publicly report in detail on our lending programs and securities purchases, including the identities of borrowers and counterparties, amounts lent or purchased, and other information, such as collateral accepted. In late 2010, we posted detailed information on our public website about more than 21,000 individual credit and other transactions conducted to stabilize markets during the financial crisis. And, just last Friday, we posted the first in an ongoing series of quarterly reports providing a great deal of information on individual discount window loans and securities transactions. The Federal Reserve's financial statement is audited by an independent, outside accounting firm, and an independent Inspector General has wide powers to review actions taken by the Board. Importantly, the Government Accountability Office (GAO) has the ability to--and does--oversee the efficiency and integrity of all of our operations, including our financial controls and governance.

While the GAO has access to all aspects of the Fed's operations and is free to criticize or make recommendations, there is one important exception: monetary policymaking. In the 1970s, the Congress deliberately excluded monetary policy deliberations, decisions, and actions from the scope of GAO reviews. In doing so, the Congress carefully balanced the need for democratic accountability with the benefits that flow from keeping monetary policy free from short-term political pressures.

However, there have been recent proposals to expand the authority of the GAO over the Federal Reserve to include reviews of monetary policy decisions. Because the GAO is the investigative arm of the Congress and GAO reviews may be initiated at the request of members of the Congress, these reviews (or the prospect of reviews) of individual policy decisions could be seen, with good reason, as efforts to bring political pressure to bear on monetary policymakers. A perceived politicization of monetary policy would reduce public confidence in the ability of the Federal Reserve to make its policy decisions based strictly on what is good for the economy in the longer term. Balancing the need for accountability against the goal of insulating monetary policy from short-term political pressure is very important, and I believe that the Congress had it right in the 1970s when it explicitly chose to protect monetary policy decision making from the possibility of politically motivated reviews.

Conclusion
In conclusion, I will simply note that these past few years have been a difficult time for the nation and the economy. For its part, the Federal Reserve has also been tested by unprecedented challenges. As we approach next year's 100th anniversary of the signing of the Federal Reserve Act, however, I have great confidence in the institution. In particular, I would like to recognize the skill, professionalism, and dedication of the employees of the Federal Reserve System. They work tirelessly to serve the public interest and to promote prosperity for people and businesses across America. The Fed's policy choices can always be debated, but the quality and commitment of the Federal Reserve as a public institution is second to none, and I am proud to lead it.

Now that I've answered questions that I've posed to myself, I'd be happy to respond to yours.

---

1. The Fed has a number of ways to influence short-term rates; basically, they involve steps to affect the supply, and thus the cost, of short-term funding.

Homework 1

Economics 470/570 
Fall 2012
Answers will be posted on Thursday, 10/4

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.

Lecture 2 on Thursday 9/27/2012

Brief Outline of Topics Covered in Lecture 2

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 Money Data?

Chapter 4 Understanding Interest Rates [pages 81-84]

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 [We may start this section, but we won't get too far if we do.]

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

Video

Material from class:

Extra Reading:

The stone money of Yap is an interesting case to consider when thinking about what money is and what role it plays in the economic and social affairs of a community. This article by Michael Bryan of the Federal Reserve Bank of Cleveland describes the stone wheels of Yap, how they were obtained and used as gift markers both within and between tribes, and whether the stones fit the textbook definition of money:

Federal Reserve Bank of Cleveland, Island Money, by Michael F. Bryan: ...In this Commentary, I … consider… the unique and curious money of Yap, a small group of islands in the South Pacific. … For at least a few centuries leading up to today, the Yapese have used giant stone wheels called rai when executing certain exchanges. The stones are made from a shimmering limestone that is not indigenous to Yap, but quarried and shipped, primarily from the islands of Palau, 250 miles to the southwest. The size of the stones varies; some are as small as a few inches in diameter and weigh a couple of pounds, while others may reach a diameter of 12 feet and weigh thousands of pounds. A hole is carved into the middle of each stone so that it may be carried, either by coconut rope strung through the smaller pieces, or by wooden poles inserted into the larger stones. These great stones require the combined effort of many men to lift. Expeditions to acquire new stones were authorized by a chief who would retain all of the larger stones and two-fifths of the smaller ones, reportedly a fairly common distribution of production that served as a tax on the Yapese. In effect, the Yap chiefs acted as the island’s central bankers; they controlled the quantity of stones in circulation...

The quarrying and transport of rai was a substantial part of the Yapese economy. In 1882, British naturalist Jan S. Kubary reported seeing 400 Yapese men producing stones on the island of Palau for transport back to Yap. Given the population of the island at the time … more than 10 percent of the island’s adult male population was in the money-cutting business. Curiously, rai are not known to have any particular use other than as a representation of value. The stones were not functional, nor were they spiritually significant to their owners, and by most accounts, the stones have no obvious ornamental value to the Yapese. If it is true that Yap stones have no nonmonetary usefulness, they would be different from most “primitive” forms of money. Usually an item becomes a medium of exchange after its commodity value—sometimes called intrinsic worth—has been widely established...

Precisely how the value of each stone was determined is somewhat unclear. We know that size was at best only a rough approximation of worth and that stone values varied depending upon the cost or difficulty of bringing them to the island. For example, stones gotten at great peril, perhaps even loss of life, are valued most highly. Similarly, stones that were cut using shell tools and carried by canoes are more valuable than comparably sized stones that were quarried with the aid of iron tools and transported by large Western ships. The more valuable stones were given names, such as that of the chief for whom the stone was quarried or the canoe on which it was transported. Naming the stone may have secured its value since such identification would convey to all the costs associated with obtaining it...

Consider the case of the Irish American David O’Keefe from Savannah, Georgia, who, after being shipwrecked on Yap in the late nineteenth century, returned to the island with a sailing vessel and proceeded to import a large number of stones in return for a bounty of Yapese copra (coconut meat). The arrival of O’Keefe (and other Western traders) increased the number and size of the stones being brought back to the island, and by one accounting, Yap stones went from being “very rare” in 1840 to being plentiful—more than 13,000 were to be found on the island by 1929. No longer restricted by shell tools and canoes, the largest stones arriving grew from four feet in diameter to the colossal 12-foot stones that are now a part of monetary folklore. Yet the great infusion of stones did not inflate away their value. Since the stones of Captain O’Keefe were obviously more easily obtained, they traded on the island at an appropriately reduced value relative to the older stones gotten at much greater cost. In essence, O’Keefe and other Westerners were bringing in large numbers of “debased” stones that could easily be identified by the Yapese.

While it’s clear that the Yap stones have value for the Yapese, can the stones really be called money? The answer, of course, depends upon how you define money. If you rely on a standard textbook definition, you’d describe money in terms of its functions, for example, “Whatever is used as a medium of exchange, unit of account, and store of value.” Certainly, Yap stones performed at least one of these functions quite well—they were an effective store of value (form of wealth). But every asset—from bonds to houses—stores value and is not necessarily labeled money.

To be called money, at least according to the textbook definition, an asset must serve two other functions. It must be a medium of exchange, meaning that it can be readily used either to purchase goods or to satisfy a debt, and it must be a unit of account, or something used as a measure of value. Yap stones were not the unit of account for the islands. Pricing goods and services in terms of the stones would probably have been difficult for the average islander. ... According to Paul Einzig, prices on the islands were set in terms of baskets of a food crop, taro, or cups of syrup, staples that would be easy for a typical islander to appreciate. Furthermore, there is some question whether Yap stones were commonly used as a medium of exchange. To be used in exchange, an item must possess certain characteristics—it must be storable, portable, recognizable, and divisible. Certainly, the stones were storable; they can still be found in abundance on Yap, and they have maintained their purchasing power reasonably well over time (particularly compared with other fiat monies, including dollars). And while it is sometimes claimed that Yap stones suffer as an exchange medium because they lack portability, this may not be completely accurate. In the case of the larger, more easily identified stones, physical possession is not necessary for the transfer of purchasing power. Those involved in the exchange need only communicate that purchasing power has been transferred…

But while storability and portability may not have limited the use of these stones as a medium of exchange, the other two characteristics—recognizability and divisibility—probably did. The stones were primarily used in exchanges between Yap islanders. … Yap historically did not have close cultural ties with any of its trading partners and trade with off-islanders was somewhat infrequent, the stones did not facilitate transactions on these occasions. When transacting with other islands, the Yapese used woven mats (a common exchange medium throughout the South Pacific), while trade with Westerners often involved an exchange of coconuts. Even on the island, the indivisibility of the stones necessitated the use of other items as media of exchange for most transactions. Most rai are highly valued: By one account, a stone of “three spans” (about 25 inches across) would have been sufficient in the early twentieth century to purchase 50 baskets of food or a full-sized pig, while a stone the size of a man would have been worth “many villages and plantations.” Obviously, these stones do not change hands very frequently, since expenditures of such magnitude are rare. For more ordinary transactions, the Yapese either used pearl shells or resorted to barter. Clearly the stones of Yap do not fit neatly within the textbook definition of money…

But … what role do the stones play and how is that role similar to that played by dollars?... [T]he stones, particularly the larger ones, acted as markers, changing hands in recognition of a “gift.” Stones were often merely held until the gift was reciprocated and the stone could be returned to its original owner. For example, islanders wishing to fish someone’s waters might do so by leaving a stone in recognition of the favor. After an appropriate number of fish were given to the owner of the fishing waters, the stone would simply be reclaimed. Occasionally a stone was “exchanged” when one tribe came to the aid of another, say for support against a rival tribe or in celebration of some event. But the stone would reside with the new tribe only until such time as aid of a similar value could be given in return. The stones, then, act as a memory of the contributions occurring between islanders. Anthropologists refer to this as a “gift economy,” where goods aren’t traded as much as they are given with the expectation of a comparable favor at some later date. So Yap stones serve as a memory of one’s contributions on the island. … But this raises an intriguing question. If the stones of Yap were merely markers and nothing more, why did the Yapese expend such great resources to carve them out of the mountains of Palau and carry them all the way back to their island? Wouldn’t any marker work just as well? It may be that the Yap chiefs did not have sufficient “credibility” to simply decree an object’s value. That is, the Yapese may have needed some assurance that the object on which value has been assigned could not be easily replicated for the mere benefit of the issuer...

Lecture 1 on Tuesday 9/25/2012

Brief Outline of Topics Covered in Lecture 1

Read on your own:

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

Why Study Money and Monetary Policy?

Why Study Banking and Financial Institutions?

Why Study Financial Markets?

Lecture begins here:

Chapter 2: An Overview of the Financial System (pgs 25-27, 36-41)

Direct versus Indirect Finance

Structure and Functions of Financial Markets

Structure and Functions of Financial Intermediaries

Example to illustrate functions

Chapter 3: What is Money?

Meaning of Money
Functions of Money

Medium of Exchange
Unit of Account
Store of Value

Video

Material from class:

Extra Reading:

Theories on where money comes from say something about where the dollar and euro will go, The Economist: Money is perhaps the most basic building-block in economics. It helps states collect taxes to fund public goods. It allows producers to specialize and reap gains from trade. It is clear what it does, but its origins are a mystery. Some argue that money has its roots in the power of the state. Others claim the origin of money is a purely private matter: it would exist even if governments did not. This debate is long-running but it informs some of the most pressing monetary questions of today.

Money fulfils three main functions. First, it must be a medium of exchange, easily traded for goods and services. Second, it must be a store of value, so that it can be saved and used for consumption in the future. Third, it must be a unit of account, a useful measuring-stick. Lots of things can do these jobs. Tea, salt and cattle have all been used as money. In Britain’s prisons, inmates currently favor shower-gel capsules or rosary beads.

The use of money stretches back millennia. Electrum, an alloy of gold and silver, was used to make coins in Lydia (now western Turkey) in around 650BC. The first paper money circulated in China in around 1000AD. The Aztecs used cocoa beans as cash until the 12th century. The puzzle is how people agreed what to use.

Karl Menger, an Austrian economist, set out one school of thought as long ago as 1892*. In his version of events, the monetization of an economy starts when agricultural communities move away from subsistence farming and start to specialize. This brings efficiency gains but means that trade with others becomes necessary. The problem is that operating markets on the basis of barter is a pain: you have to scout around looking for the rare person who wants what you have and has what you want.

Money evolves to reduce barter costs, with some things working better than others. The commodity used as money should not lose value when it is bought and sold. So clothing is a bad money, since no one places the same value on second-hand clothes as new ones. Instead, something that is portable, durable (fruit and vegetables are out) and divisible into smaller pieces is needed. Menger called this property “saleableness”. Spices and shells are highly saleable, explaining their use as money. Government plays no role here. The origin of money is a market-led response to barter costs, in which the best money is that which minimizes the costs of trade. Menger’s is a good description of how informal monies, such as those used by prisoners, originate.

But the story just doesn’t match the facts in most monetary economies, according to a 1998 paper** by Charles Goodhart of the London School of Economics. Take the widespread use of precious metals as money. A Mengerian would say that this happens because metals are durable, divisible and portable: that makes them an ideal medium of exchange. But it is incredibly hard to value raw metals, Mr Goodhart argued, so the cost of using them in trade is high. It is much easier to assess the value of a bag of salt or a cow than a lump of metal. Raw metals fail Menger’s own saleableness test.

This problem explains why metal money has circulated not in lumps but as coins, with a regulated amount of metal in each coin. ... That suggests another theory is needed, in which the state plays a bigger role in the origin of money. ...

Syllabus for Fall 2012

Course: Economics 470/570 Monetary Theory and Policy
Professor: Mark Thoma
Office/Hours: PLC 471 on M/W 1:30 p.m.-2:30 p.m.
Phone/Email: (541) 346-4673, [email protected]
Web Page: http://pages.uoregon.edu/mthoma/

Text: Frederic S. Mishkin, The Economics of Money, Banking, and Financial Markets, 10th edition.

Prerequisites: Economics 313 or the equivalent.

GTF/Office/Hours/Email: Adam Check, TBA, TBA, [email protected].

Tests: There will be a midterm and a final. The midterm will be given on Thursday, October 25^th, and the final will be given on Thursday, December 6^th from 1:00 p.m. – 3:00 p.m. The final is comprehensive.

Homework: Problem sets will be assigned periodically. These will not be graded, but exam questions will be based, in part, upon the problem sets.

Grading: The midterm is worth 40%, and the final is worth 60%.  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	Mishkin Text
Why Study Money, Banking, and Financial Markets?	Ch. 1
An Overview of the Financial System	Ch. 2
What is Money	Ch. 3
Understanding Interest Rates	Ch. 4,  pgs. 81-84
Central Banking and Monetary Policy
Central Banks and the Federal Reserve System	Ch. 13
The Money Supply Process	Ch. 14
Tools of Monetary Policy	Ch. 15
The Conduct of Monetary Policy	Ch. 16
Monetary Theory
Money Demand, the Quantity Theory,  and Inflation	Ch. 19
The IS Curve	Ch. 20
Monetary Policy and AD Curves	Ch. 21
The AS-AD Model	Ch. 22
Monetary Policy Theory	Ch. 23
The Role of Expectations in Monetary Policy	Ch. 24

Course materials for Fall 2011

Link to course materials for Fall 2011.

(Links to other quarters are on the sidebar.)