Brief Outline of Topics Covered in Lecture 17
Review for final exam
Video
March 16, 2014
March 12, 2014
March 11, 2014
Lecture 16 on Tuesday 3/11/2014
Brief Outline of Topics Covered in Lecture 16
Chapter 24 The Role of Expectations in Monetary Policy [continued]
- 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:
Tim Duy:
Unemployment, Wages, Inflation, and Fed Policy: I apologize if that was a misleading title. This post is not a grand, unifying theory of macroeconomics. It is instead a quick take on two posts floating around today. The first is Paul Krugman's admonishment to the Federal Reserve against raising interest rates before wages rise:
So far, no clear sign that wage growth is accelerating. Even more important, however, wages are growing much more slowly now than they were before the crisis. There is no argument I can think of for not wanting wage growth to get at least back to pre-crisis levels before tightening. In fact, given that we’ve now seen just how dangerous the “lowflation” trap is, we should be aiming for a significantly higher underlying rate of growth in wages and prices than we previously thought appropriate.
I don't think that you should be surprised if the Federal Reserve starts raising rates well before wage growth returns to pre-crisis rates. I think you should be very surprised if the Fed were to do as Krugman suggests. Historically, the Fed tightens before wages growth accelerates much beyond 2%:
As I have noted earlier, wage growth tends to accelerate as unemployment approaches 6 percent, and so if you wanted to be ahead of inflation, they would be thinking about the first rate hike in the 6.0-6.5% range. That 6.5% threshold was not pulled out of thin air.
The second point is that the tightening cycle is usually topping out when wage growth is in the 4.0-4.5% range. One interpretation is that the Fed continues to tighten policy to prevent workers from gaining too much of an upper-hand, thereby contributing to growing wage inequality. Of course, I doubt they see it that way. They see it as tightening monetary conditions to hold inflation in check. Either way, the end is the same. It would represent a very significant departure from past policy if the Fed waited until wage growth was at pre-recession rates before they tightened policy or if they allow conditions to remains sufficiently loose for wage growth to eventually rise above pre-recession rates.
If you want the Fed to make such a departure, start laying the groundwork soon. The best I can offer is my expectation that Fed Chair Janet Yellen is more inclined than the average policymaker to wait until wages actually rise before acting. I have trouble believing that even she would wait until wage growth accelerates to pre-recession trends.
Second, the Washington Post's Ylan Mui has this:
But a funny thing happens once unemployment hits 6.5 percent: The behavior of inflation starts to become random, as illustrated in this chart by HSBC chief U.S. economist Kevin Logan.
The black line represents the average annual unemployment rate for the past 30 years. You can see that in all but two cases (both of which were temporary shocks), inflation declined when the jobless rate was above 6.5 percent. But when unemployment rate fell below that point, inflation was almost as likely to increase as it was to decrease. In other words, what happens to inflation below the Fed’s threshold is anybody’s guess.
I would take issue with the idea that inflation behavior becomes "random" at unemployment rates below 6.5%. You need to consider this kind of chart in the context of expected inflation and expected policy. If inflation expectations are stable, and if the Federal Reserve provides policy to ensure that stability, you would expect random errors around expected inflation. Couple this with downward nominal wage rigidities, and you should expect the same even under circumstances of high unemployment. Here is my version of the same chart:
The data is monthly. This y-axis is the change in inflation from a year ago, where inflation is measured as the year-over-year change in core-pce. Unsurprisingly, since 2000, changes in core-inflation vary around zero. Stable and low inflation expectations. During periods of the 1970's and 1980's you see the impact of unstable expectations as the relationship circles all over the place. But you also see the general pattern of disinflation since the early 1980's with the downward sloping relationship and many inflation observations, even at low unemployment rates, below zero.
Now it is fairly easy to put both of these posts together. The Fed, wanting to ensure stable inflation expectations, begins raising interest rates well before wage rates begin rising. This is turn controls the growth of actual inflation so that inflation rates do not rise as unemployment falls further. The deviations of inflation from expectations are then just noise. But actual inflation is not "random." It is the result of specific monetary policy.
Bottom Line: If the Fed follows historical behavior, they will begin tightening before wages rise and in an environment of low inflation such that inflation remains stable even as unemployment falls. In other words, in recent history that have not exhibited a tendency to overshoot. Explicit overshooting would represent a very significant shift in the Fed's modus operandi.
March 05, 2014
Lecture 15 on Thursday 3/6/2014
Brief Outline of Topics Covered in Lecture 15
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:
Tim Duy:
Fed Talk Shifts to Higher Rates, by Tim Duy: First off, sorry for the limited blogging of recent weeks. In the weeds at the office and the time to complete my winter to-do list before spring break is growing short.
With the end of asset purchases in sight (and assuming activity does not lurch downward) Fed officials will increasingly turn the discussion toward raising interest rates. It is not as if the anticipated time line has been any secret. The Fed's forecasts clearly show an expectation of higher rates in 2015 with the exact timing and pace of that tightening dependent upon each participant's growth and inflation forecast. Fed officials would want to clearly telegraph such a move well in advance. Hence they will pivot from talk of sustained low rates to raising rates. Of course, we would expect hawks to be first in line, as they have been. For instance, Philadelphia Federal Reserve President said last week (via the Wall Street Journal):
“Most formulations of standard, simple policy rules suggest that the federal funds rate should rise very soon–if not already,” Mr. Plosser told a conference sponsored by the University of Chicago‘s Booth School of Business.
Such warnings from Plosser are not new. More notable is San Fransisco Federal Reserve President John Williams' interview with Robin Harding at the Financial Times. Williams is generally seen as a dove, but he was also was one of the first to telegraph the end of asset purchases. Williams on the forecast:
In his own economic forecast, Mr Williams said, the Fed will raise interest rates in the middle of next year with the unemployment rate at about 6 per cent, inflation at 1.5 per cent and “everything moving in the right direction”.“At that point if we don’t start to adjust monetary policy there’d be a risk of overshooting,” he said. “You don’t wait until you’re at full employment before you start to raise interest rates from zero.”
There is a lot to think about in those two paragraphs. First is a forecast of 6% unemployment 15 months or so from now. Given the rapid drop in the unemployment rate, it is completely believable that we reach 6% before asset purchases are predicted to end later this year. Given Williams' forecast, this suggests to me that the risk here is a more rapid tapering or earlier rate hike. The second is the idea of raising rates when inflation is only 1.5%. This to me suggests that Williams is expecting to reach the 2% target from below, not above. This seems clear from the next point: Williams wants to take the possibility of overshooting off the table.
Note that Williams' position differs greatly from that of Chicago Federal Reserve President Charles Evans. From a speech last week:
A slow glide toward our goals from large imbalances risks being stymied along the way and is more likely to fail if adverse shocks hit beforehand. The surest and quickest way to get to the objective is to be willing to overshoot in a manageable fashion. With regard to our inflation objective, we need to repeatedly state clearly that our 2 percent objective is not a ceiling for inflation. Our “balanced approach” to reducing imbalances clearly indicates our symmetric attitudes toward our 2 percent inflation objective.
Evans is obviously willing to overshoot, where Williams is not. Whether the consensus sides with Williams or Evans is critical to the timing of the first rate hike. If the consensus is set on hitting the inflation target from below, then we have have to consider the Fed's own forecasts as suspect. They will find themselves moving sooner than they expect.
I would say, however, it is widely believed, on the basis of her "optimal control" analysis, that Federal Reserve Chair Janet Yellen leans toward Evans. Any suggestion that Yellen leans toward Williams on the overshooting question would be notable.
Regarding asset purchases, Williams joins the chorus indicating the bar to change is high:
Mr Williams said it would take a “substantial change in the outlook” before he was willing to revisit the Fed’s plan to slow purchases by $10bn at each meeting, and despite some weak data, that has not yet happened. “We haven’t really changed our basic outlook for the economy.”......Mr Williams said that as long as average monthly jobs growth stays well above 100,000 then unemployment will continue to come down. “What would worry you is if you don’t have an explanation for why it’s weaker and you get multiple months below that,” he said.
I don't think this should come as a surprise. The Fed has been looking to get out of the asset purchase business since the beginning of 2013. The end is now in sight, and only the most disconcerting of data will change that. They may say they are data dependent (Williams of course adds that he could envision circumstances in which the Fed slow or even reverse tapering), but the reality is they have a bias against asset purchases.
The desire to exit asset purchases only increases as the unemployment rate falls. I think that Joe Weisenthal is on the money here when he points out that economists are gravitating toward the idea the the changes in the labor market are largely structural. In other words, as St. Louis Federal Reserve puts it (via the Wall Street Journal):
“I think that unemployment is really sending the right signal about the labor market” and the decline in the labor force participation rate is largely a demographic issue that will play out over a long time horizon, he said.
I think that Fed officials have long seen the risk that this might be true, which is one factor that biases them against asset purchases. Increasing, though, I suspect they do not see is as a risk, but as reality. Again, the consequence is that rates might be rising sooner than Fed officials currently anticipate. It is worth repeating this chart:
In the past, wage growth accelerates as unemployment hits 6%. With unemployment well above 6%, it was difficult to conclusively say much one way or another about the exact amount of slack in the labor market as there was certainly enough slack to keep wage growth in check. If the unemployment rate is no longer the appropriate indicator of labor market slack, then we should not expect to see upward wage pressure as 6% looms. If that pressure does emerge, then I think we learn something about the amount of slack. From the Fed's point of view, if they see wage growth, they will suspect their isn't much. Wage growth will raise concerns about unit labor costs, which will in turn raise concerns about inflation.
Weisenthal, however, adds:
The view from the left is basically: Even if the labor market is getting tight (which they deny), the Fed should press hard on the gas pedal, so that employers start to employ the long-term unemployed.And that might be the proper path, and if there's anyone who has the stomach to engage in the strategy, it's probably Janet Yellen.
Once again, this implies that Yellen is willing to risk overshooting. Her views on overshooting are critical to the evolution of policy at this point.
Bottom Line: Put aside the possibility of an international crisis-fueled collapse in activity. The Fed's baseline view is that economic growth continues this year at a pace sufficient to end the asset purchase program. The Fed will resist changing that plan for any minor stumble in activity. The pace of job creation itself might not be that critical; it simply needs to be fast enough to lower unemployment to justify continuing the taper. Moreover, we are reaching a point where the Fed will need to decide to what extent it will risk overshooting. That was never really a risk of overshooting above 6% unemployment. Soon it will be an interesting question. The timing of the first rate hike and the subsequent tightening is dependent upon the consensus on overshooting. If wage growth starts to accelerate, the Fed's focus will shift from fears of too much to too little slack. If they are concerned about overshooting, they will need to accelerate the tightening time line. Where Yellen ultimately falls on the issue is critical.
March 03, 2014
February 25, 2014
February 20, 2014
Lecture 12 on Thursday 2/20/2014
Brief Outline of Topics Covered in Lecture 12
Chapter 22 Aggregate Demand and Supply Analysis [continued]
The Aggregate Supply Curve
- 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
Chapter 23 Monetary Policy Theory [probably won't get very far into this chapter, if at all]
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:
The Liberty Street Economics blog at the NY Fed analyzes the latest Household Debt and Credit Report (see Calculated Risk as well):
Just Released: Who’s Borrowing Now? The Young and the Riskless!, by Andrew Haughwout, Donghoon Lee, Wilbert van der Klaauw, and David Yun: According to today’s release of the New York Fed’s 2013:Q4 Household Debt and Credit Report, aggregate consumer debt increased by $241 billion in the fourth quarter, the largest quarter-to-quarter increase since 2007. More importantly, between 2012:Q4 and 2013:Q4, total household debt rose $180 billion, marking the first four-quarter increase in outstanding debt since 2008. As net household borrowing resumes, it is interesting to see who is driving these balance changes, and to compare some of today’s patterns with those of the boom period.
The next two charts show contributions to changes in debt balances by borrower age, first when household credit was expanding rapidly in 2006, and then in 2013. For each age group, the charts show the percentage change in aggregate debt outstanding for each type. Thus, summing the numbers for a given loan type produces the overall percentage growth for that type over the relevant four-quarter period.
A couple of things stand out. First, overall growth in debt remains considerably more muted in 2013 than it was in 2006, with the exception of auto loans, where 2013 data continued to reflect the strong growth we have been seeing since mid-2011, and student loans. (In the case of student loans, the percentage growth has moderated since 2006, but since the outstanding balance has doubled, the lower percentage growth is associated with comparable dollar increases.) Mortgage and home equity line of credit (HELOC) balances, in particular, grew much more slowly in 2013 than in 2006. Second, for all loan types and in both years, balance increases were mainly driven by younger age groups. Again, though, student loans are an exception: even older student loan borrowers continue to increase their borrowing.
The next two charts break down the same data, this time by Equifax risk score (or credit score) groups.
On the credit score breakdown we see stark differences in patterns for mortgages and HELOCs between the 2013 and 2006 cohorts. Notably, in 2013, balances fell for the lowest credit score borrowers—the result of charge-offs from previous foreclosures—while all groups, even those with subprime credit scores, increased their mortgage balances in 2006. Now, the modest mortgage balance increases we see are mainly coming from high credit score borrowers.
A similar picture emerges for credit card balances. Note, though, that credit card balances for subprime borrowers were falling in 2006, again mostly due to charge-offs, making the increased mortgage balance for that group in 2006 seem all the more remarkable.
There’s been a tremendous amount of attention to the growth of student loans in recent years, and these charts indicate some of the reason why. First, student loans grew the most of any debt product in both periods (in percentage terms). Second, the growth in educational debt, like that of auto loans, is concentrated among the lower and middle credit score groups.
But auto and student loans have been growing for some time, while overall debt continued to fall. In 2013, the increased credit card and mortgage debt among the young and the riskless led to a turnaround in the trajectory of overall debt.
For a more detailed look at net borrowing by age and credit score in 2006 and 2013, please take a look at our interactive graphic.
Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
February 18, 2014
February 12, 2014
Lecture 10 on Thursday 2/13/2014
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:
Yellen's Debut as Chair, by Tim Duy: Janet Yellen made her first public comments as Federal Reserve Chair in a grueling, nearly day-long, testimony to the House Financial Services Committee. Her testimony made clear that we should expect a high degree of policy continuity. Indeed, she said so explicitly. The taper is still on, but so too is the expectation of near-zero interest rates into 2015. Data will need to get a lot more interesting in one direction or the other for the Fed to alter from its current path.
In here testimony, Yellen highlighted recent improvement in the economy, but then turned her attention to ongoing underemployment indicators:
Nevertheless, the recovery in the labor market is far from complete. The unemployment rate is still well above levels that Federal Open Market Committee (FOMC) participants estimate is consistent with maximum sustainable employment. Those out of a job for more than six months continue to make up an unusually large fraction of the unemployed, and the number of people who are working part time but would prefer a full-time job remains very high. These observations underscore the importance of considering more than the unemployment rate when evaluating the condition of the U.S. labor market.
A visual reminder of the issue:
This is a straightforward reminder of the Fed's view that the unemployment rate overstates improvement in labor markets and thus should be discounted when setting policy. Consequently, policymakers believe they have room to hold interest rates at rock bottom levels for an extended period. To be sure, there are challenges to this view, both internally and externally. For instance, Philadelphia Federal Reserve President Charles Plosser today reiterated his view that asset purchases should end soon and also fretted that the Fed will be behind the curve with respect to interest rates. Via Bloomberg:
“I’m worried that we’re going to be too late” to raise rates, Plosser told reporters after a speech at the University of Delaware in Newark. “I don’t want to chase the market, but we may have to end up having to do that” if investors act on anticipation of higher rates.
That remains a minority view at the Fed. Matthew Boesler at Business Insider points us at UBS economists Drew Matus and Kevin Cummins, who challenge Yellen's belief that the long-term unemployed will keep a lid on inflation:
We do not view the long-term unemployed as necessarily "ready for work" and therefore believe that their ability to restrain wage pressures is limited. In other words, the unusually high number of long-term unemployed suggests that the natural rate of unemployment has increased. Indeed, when we have tested various unemployment rates' ability to predict inflation we found that the standard unemployment rate outperforms all other broader measures reported by the Bureau of Labor Statistics. Although we disagree with Yellen regarding the long-term unemployed, our research does suggest that, perhaps unsurprisingly, the number of part-timers does have an impact on restraining inflation.
I tend to think that we will not see clarity on this issue until unemployment approaches even nearer to 6%. That level has traditionally been associated with rising wages pressures in the past:
The Fed would likely see a faster pace of wage gains as lending credence to the story that the drop in labor force participation is mostly a structural story. At that point the Fed may begin rethinking the expected path of interest rates, depending on their interest in overshooting. But in the absence of such early signs of inflationary pressures, the Fed will be content to raise rates only gradually.
With regards to monetary policy, Yellen reminds everyone that she helped design the current policy:
Turning to monetary policy, let me emphasize that I expect a great deal of continuity in the FOMC's approach to monetary policy. I served on the Committee as we formulated our current policy strategy and I strongly support that strategy, which is designed to fulfill the Federal Reserve's statutory mandate of maximum employment and price stability.
Yellen makes clear that the current pace of tapering is likely to continue:
If incoming information broadly supports the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings.
Later, during the question and answer period, Yellen does however, open the door for a pause in the taper. Via Pedro DaCosta and Victoria McGrane at the Wall Street Journal:
“I think what would cause the committee to consider a pause is a notable change in the outlook,” Ms. Yellen told lawmakers......“I was surprised that the jobs reports in December and January, the pace of job creation, was running under what I had anticipated. But we have to be very careful not to jump to conclusions in interpreting what those reports mean,” Ms. Yellen said. Recent bad weather may have been a drag on economic activity, she added, saying it would take some time to get a true sense of the underlying trend.
The January employment report was something of a mixed bag, with the unemployment rate edging down further to 6.6% while nonfarm payrolls disappointed again (!!!!) with a meager gain of 113k. That said, I still do not believe this should dramatically alter your perception of the underlying pace of activity. Variance in nonfarm payrolls is the norm, not the exception:
Her disappointment in the numbers raises the possibility - albeit not my central case - that another weak number in the February report could prompt a pause. My baseline case, however, is that even if it was weak, it would not effect the March outcome but instead, if repeated again, the outcome of the subsequent meeting. Remember, the Fed wants to end asset purchases. As long as they believe forward guidance is working, they will hesitate to pause the taper.
Yellen was not deterred by the recent turmoil in emerging markets:
We have been watching closely the recent volatility in global financial markets. Our sense is that at this stage these developments do not pose a substantial risk to the U.S. economic outlook. We will, of course, continue to monitor the situation.
Yellen reiterates the current Evans rule framework for forward guidance, giving no indication that the thresholds are likely to be changed. Jon Hilsenrath at the Wall Street Journal interprets this to mean that when the 6.5% unemployment rate threshold is breached, the Fed will simply switch to qualitative forward guidance. I tend to agree.
Bottom Line: Circumstances have not change sufficiently to prompt the Federal Reserve deviate from the current path of policy.
February 10, 2014
Lecture 9 on Tuesday 2/11/2014
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:
When Will the Fed End Its Zero Rate Policy?, by Jens Christensen, FRBSF Economic Letter: The severe shock of the 2007–08 financial crisis prompted the Federal Reserve to quickly lower its target for its primary policy rate, the overnight federal funds rate, near to zero, where it has remained since. Despite this highly stimulatory stance of conventional monetary policy, the economic recovery has been sluggish and inflation has been low. For that reason, the Federal Open Market Committee (FOMC), the Fed’s policy body, has provided additional monetary stimulus by using unconventional measures to push down longer-term interest rates. One element of this unconventional policy has been large-scale asset purchases (LSAPs). Another has been public guidance about how long the FOMC expects to keep its federal funds rate target exceptionally low. The effect of this forward guidance depends on how financial market participants interpret FOMC communications, in particular when they expect the Fed to exit from its near-zero rate policy, a shift often called “liftoff” (see Bauer and Rudebusch 2013).
This Economic Letter examines recent research estimating when bond investors expect liftoff to take place (see Christensen 2013). This research suggests that bond investor expectations for the date of exit have moved forward notably in recent months, probably because they anticipated the FOMC’s decision at its December 2013 meeting to cut back large-scale asset purchases. This research suggests that market participants expect the FOMC to start raising rates in the spring of 2015, but the exact timing is highly uncertain.
Unconventional monetary policy
Unconventional monetary policy designed to put downward pressure on longer-term interest rates has two aspects: large-scale asset purchases and forward guidance, that is, Fed communications about its expectations for future policy. LSAPs affect longer-term interest rates by shifting the term premium, the higher yield investors demand in exchange for holding a longer-duration debt security (see Gagnon et al. 2011). LSAPs were first announced in late 2008. The most recent program, initiated in September 2012, originally involved purchasing $40 billion in mortgage-backed securities (MBS) every month. It expanded in December 2012 to include $45 billion in monthly Treasury security purchases. The FOMC stated that it intended to continue the program until the outlook for the labor market improved substantially, provided inflation remained stable. Since then, the labor market has improved and the unemployment rate has dropped. As a result, the FOMC decided at its December 2013 meeting to reduce the pace at which it adds to its asset holdings to $75 billion per month.
Forward guidance affects longer-term rates by influencing market expectations about the level of short-term interest rates over an extended period. In August 2011, the FOMC stated that it intended to keep its federal funds rate target near zero until mid-2013, the first time it projected a liftoff date. More recently, Fed policymakers have indicated that they anticipate keeping the federal funds rate at that exceptionally low level at least as long as the unemployment rate remains above 6½%, inflation one to two years ahead is projected to be no more than one-half percentage point above the FOMC’s 2% longer-run target, and longer-term inflation expectations remain in check. In December 2013, the FOMC added that, based on current projections, it expects to maintain the zero interest rate policy well past when the unemployment rate falls below 6½%.
Figure 1
FOMC member projections of appropriate policy rate
FOMC projections versus Treasury market data
Forward guidance also includes a set of projections on future federal funds rate levels that each FOMC participant makes four times per year, released in conjunction with the FOMC statement. Based on their views of appropriate monetary policy, these policymakers also forecast overall inflation; core inflation, which excludes volatile food and energy prices; the unemployment rate; and output growth. Figure 1 shows FOMC median, 25th percentile, and 75th percentile federal funds rate projections made in September and December. Only minor changes occurred from September to December.
Figure 2
Treasury yield curves on three dates in 2013
The relatively stable FOMC projections stand in contrast to changes in the U.S. Treasury bond market over the same period. Figure 2 shows the Treasury yield curve, that is, yields on the full range of Treasury maturities, on the days of the September and December 2013 FOMC meetings as well as the December 27 reading. (The research is based on weekly Treasury yields recorded on Fridays. December 27 was the last Friday in 2013.) Medium- and longer-term Treasury yields increased notably during that period.
Other analysis suggests that much of this increase in longer-term Treasuries reflected an increase in the term premium. But did the rise in longer-term rates also involve a shift in the market’s views about expected short-term rates that seems out-of-step with FOMC guidance? To address this question, I use an innovative model of the Treasury yield curve developed in Christensen (2013) that delivers a distribution of estimates derived from Treasury security prices for the exit from the zero interest rate policy.
A model of the Treasury yield curve
In this model, it is assumed that the economy can be in one of two states: a normal state like that which prevailed before December 2008, and a state like the current one in which the monetary policy rate is stuck at its lower bound near zero. In the normal state, yield curve variation is captured by three factors that are not directly observable, but can be derived from the underlying data: the general level of rates; the slope of the yield curve; and the curvature, or shape, of the yield curve. Furthermore, it is assumed that, in the normal state, investors consider the possibility of the policy rate reaching zero to be negligible. This assumption implies that the transition to the zero-bound state that occurred in December 2008 was a surprise and did not affect bond prices before that, when the economy was in the normal state.
The zero-bound state is characterized by two key features. First, the shortest rate in the Treasury bond market is assumed to be constant at zero. Second, the state is viewed by bond investors and monetary policy makers as undesirable and temporary. They believe that the FOMC would like to return to normal as quickly as possible, consistent with the Fed’s price stability and maximum employment mandates. This implies that news about the U.S. economy prompts bond investors to revise their views about when the FOMC is likely to exit from its zero interest rate policy. In the model, that exit defines the transition from the zero-bound state to the normal state of the economy. One component of the variation of Treasury bond yields in the zero-bound state is how probable bond investors believe a return to the normal state to be. However, because bond investors are forward looking and consider the possibility of such a shift when they trade, the three factors that affect the yield curve in the normal state continue to affect it in the zero-bound state.
Figure 3
Intensity of exit time from the zero interest rate policy
Results
To derive estimates of the date of the FOMC’s first federal funds rate increase, I use weekly Treasury yields starting in January 1985 of eight maturities ranging from three months to ten years. The novel feature of the model I use is consideration of the implicit probability bond investors attach to a transition back to the normal state. This allows the entire distribution of probable dates of exit from the zero-bound state to be examined. Figure 3 shows the likelihood of leaving the zero-bound state at any point in time as of December 27, 2013. The exit date distribution is heavily skewed so that very late exit times are significantly probable. Still, the median exit date is in March 2015. In other words, the economy is just as likely to remain in the zero-bound state at that date as to have exited before it. One takeaway is the considerable level of uncertainty about the exit date. The model suggests that there is about a one-in-three chance of remaining in the zero-bound state past 2015.
Figure 4
Median exit time from the zero interest rate policy
Figure 4 shows the variation in the estimated median exit time since December 16, 2008, when the economy shifted to the zero-bound state. Included are five dates from 2009 to 2012 of major FOMC announcements regarding LSAPs or guidance about future monetary policy. The estimated median exit time from the zero-bound state moved notably later in the weeks after each announcement, except when the FOMC extended its forward guidance in January 2012. This suggests that unconventional policies derive part of their effect by sending signals that bond market participants interpret to mean that the federal funds rate will remain at its zero bound longer than previously expected (see Christensen and Rudebusch 2012).
Consistent with these observations, Figure 4 also shows that the estimated median exit date from the near-zero federal funds rate moved forward significantly between the September and December 2013 FOMC meetings as market participants began anticipating the Fed’s decision to scale back LSAPs. According to the model, in anticipating the decision to trim LSAPs, the market also thought the first federal funds rate hike might come sooner than previously anticipated. This latter change in expectations held even though the FOMC’s projections of the appropriate future fed funds rate hardly changed from September to December. As of December 27, 2013, the median exit time for the market was estimated at one year and three months, which implies that the odds of keeping the near-zero interest rate policy past March 2015 are identical to the odds of exiting before that date.
Conclusion
A novel model of the Treasury yield curve allows an assessment of investor expectations of the exit date from the Fed’s near-zero interest rate policy. The results suggest that, as of the end of 2013, the expected exit date has moved forward notably since September 2013 despite only minor changes between September and December in FOMC participants’ projections of appropriate future monetary policy. However, the estimated distribution of the probable exit date is skewed so that the likelihood of an earlier or later exit is sizable. This finding is consistent with the inherent uncertainty about the outlook for inflation and unemployment, the economic variables that guide FOMC rate decisions.
References
Bauer, Michael, and Glenn Rudebusch. 2013. “Expectations for Monetary Policy Liftoff.” FRBSF Economic Letter 2013-34 (November 18).
Christensen, Jens H. E. 2013. “A Regime-Switching Model of the Yield Curve at the Zero Bound.” FRB San Francisco Working Paper 2013-34.
Christensen, Jens H. E., and Glenn D. Rudebusch. 2012. “The Response of Interest Rates to U.S. and U.K. Quantitative Easing.” Economic Journal 122, pp. F385–F414.
Gagnon, Joseph, Matthew Raskin, Julie Remache, and Brian Sack. 2011. “The Financial Market Effects of the Federal Reserve’s Large-Scale Asset Purchases.” International Journal of Central Banking 7(1), pp. 3–43.
[Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System.]
February 03, 2014
Lecture 8 on Tuesday 2/4/2014
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
Money and Inflation
The Government Budget Constraint and Inflation
Is Velocity a Constant?
Keynes’s Liquidity Preference TheoryFurther Developments in the Keynesian Approach
- Transactions Motive
- Precautionary Motive
- Speculative Motive
- Putting the Three Motives Together
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.
January 28, 2014
January 27, 2014
January 23, 2014
Lecture 6 on Thursday 1/23/2014
Brief Outline of Topics Covered in Lecture 6
Chapter 14 Multiple Deposit Creation and the Money Supply Process [cont.]
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, MBn
- Changes in Borrowed Reserves, BR, from the Fed
Chapter 15 Tools of Monetary Policy
The Market for Reserves and the Federal Funds Rate
- Supply and Demand in the Market for Reserves
- Tools of monetary policy: Open Market Operations, Discount Policy, and Reserve Requirements
Video:
Application:
Why Do Banks Feel Discount Window Stigma?,by Olivier Armantier, Liberty Street, FRBNY: Even when banks face acute liquidity shortages, they often appear reluctant to borrow at the New York Fed’s discount window (DW) out of concern that such borrowing may be interpreted as a sign of financial weakness. This phenomenon is often called “DW stigma.” In this post, we explore possible reasons why banks may feel such stigma.
The problem of stigma has been a lingering issue throughout the history of the DW. Prior to 2003, banks in distress could borrow from the DW at a rate below the fed funds target rate. Because of the subsidized rate, the Fed was concerned about “opportunistic overborrowing” by banks. Accordingly, before accessing the DW, a bank had to satisfy the Fed that it had exhausted private sources of funding and that it had a genuine business need for the funds. Hence, if market participants learned that a bank had accessed the DW, then they could reasonably conclude that the bank had limited sources of funding. The old DW regime therefore created a legitimate perception of stigma.
To address such stigma concerns, the Fed fundamentally changed its DW policy in 2003. In Regulation A, as revised in 2003, the Fed classified DW loans into primary credit, secondary credit, and seasonal credit. Financially strong and well-capitalized banks can borrow under the primary credit program at a penalty rate above the target fed funds rate (rather than a subsidized rate, as in the past). Other banks can use the secondary credit program and pay a rate higher than the primary credit rate. Finally, seasonal credit is for relatively small banks with seasonal fluctuations in reserves. For banks eligible for primary credit, the new DW is a “no-questions-asked” facility. Namely, the Fed no longer establishes a bank’s possible sources and needs for funding to lend under the primary credit program. Instead, primary credit for overnight maturity is allocated with minimal administrative burden on the borrower. Hence, access to primary credit need not be motivated by pressing funding needs nor signal financial weakness. In other words, there’s no structural reason why stigma should be attached to the new DW.
Nevertheless, stigma concerns resurfaced in 2007 at the onset of the recent financial crisis. In fact, as adverse liquidity conditions in the interbank markets persisted at the end of 2007, the Fed had to put in place a temporary facility, the Term Auction Facility (TAF), which was specifically designed to eliminate any perception of stigma attached to borrowing from the DW. Further, as discussed in a previous post, there’s strong evidence that banks experienced DW stigma during the most recent financial crisis.
So why do banks still feel DW stigma? In a recent staff report, we explored different hypotheses related to factors that may exacerbate or attenuate DW stigma. To conduct our analysis, we compared the DW rate with the bids each bank submitted at the TAF between December 2007 and October 2008. As explained in our paper, it can be shown with a simple arbitrage argument that, absent DW stigma, a TAF bidder should never bid above the prevailing DW rate. We therefore interpreted a bank bidding above the DW rate as evidence of DW stigma. Then, we conducted an econometric analysis to identify a bank’s possible determinants of DW stigma. Among the various hypotheses we tested, we report here the most interesting.
- Banks outside the New York District: A necessary condition for DW stigma to exist is that banks must believe there’s a chance their identities will be made public soon after they borrow from the DW. Although central banks don’t immediately disclose the borrower’s identity, it’s been argued that DW borrowers may be identified from the Fed’s weekly public report, in which DW borrowings aggregated by Federal Reserve District are published. This identification channel may be especially relevant for banks in smaller Districts. Indeed, DW borrowing by an institution in a smaller District may be easier to detect. To test this hypothesis, our study focused on the Second Federal Reserve District (which covers the New York region) — the largest of the twelve Federal Reserve Districts in terms of the number of banks supervised. Consistent with the hypothesis, our results showed that banks in the New York District were 14 percent less likely to experience DW stigma than their counterparts in smaller Districts.
- Foreign banks: It’s also possible that foreign institutions with access to primary credit at the Fed are especially sensitive to DW stigma. Indeed, in contrast with their U.S. counterparts, foreign banks typically don’t have access to retail dollar deposits that are insured by the Federal Deposit Insurance Corporation. As a result, foreign banks must often rely on wholesale debt investors (such as money market funds), which are highly sensitive to credit risk. In other words, because their investors may be sensitive to any negative information, foreign banks may be particularly concerned about the risk of being detected taking a loan at the DW. Again, we found strong evidence to support this hypothesis. Specifically, our results suggested that branches and agencies of foreign banks were 28 percent more likely to experience DW stigma than their U.S. counterparts with otherwise similar characteristics.
- Herding effect: Intuitively, DW stigma may be expected to reflect a coordination problem. If an institution is the only one borrowing at the DW, then it’s likely to be stigmatized. However, the stigma from accessing the DW should be lower if many other institutions do so at the same time. However, we found no support for this hypothesis. Specifically, our results suggested that the stigma attached to borrowing at the DW didn’t decline when more banks accessed it during the 2007-08 period. To explore this question in more detail, we also tested whether there’s a form of herding or contagion effect, whereby a bank’s DW stigma declines when more banks within its own peer group (as measured by asset size) go to the DW. Again, the results from our regressions provided no evidence of such a herding effect.
- Market conditions: In times of financial crises, there’s often intense speculation about the health of various financial institutions. In particular, public news that may be considered negative (such as a bank visit to the DW that becomes public) is likely to be amplified beyond its informational content. As a result, banks may go to greater expense to avoid borrowing at the DW. One may therefore expect DW stigma to increase when financial markets become more stressed. To test this hypothesis, our study considered three variables that capture aggregate funding conditions and volatility in financial markets: the Libor-OIS spread, a stress indicator for the interbank and money markets; the VIX level, a measure of the forward-looking volatility of the U.S. stock market as implied by options prices; and the CDX IG index of CDS prices, a measure of economy-wide default probability. Consistent with the hypothesis, we found that DW stigma was positively related to each of the three measures of stress in financial markets.
In summary, our study provided a better understanding of the reasons why banks may feel DW stigma. In particular, we found that the incidence of DW stigma was higher for foreign banks, banks that could be identified more easily, and banks outside the New York Federal Reserve District, as well as after financial markets became stressed. In contrast, we found no evidence that DW stigma may be due to a lack of coordination among banks when accessing the DW.
Disclaimer
The views expressed in this post are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author.
Olivier Armantier is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.
January 21, 2014
Lecture 5 on Tuesday 1/21/2014
Brief Outline of Topics Covered in Lecture 5
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, MBn
- Changes in Borrowed Reserves, BR, from the Fed
- Currency and Deposits
Video
Extra Reading:
Tim Duy:
The Week That Was, by Tim Duy: Plenty of data and Fedspeak to chew on last week, the sum total of which I think point in the same general direction. Economic activity is on average improving modestly, the Federal Reserve will push through with another round of tapering next week, and low inflation continues to hold back the threat of rate hikes.
After stripping out the auto component, retail sales were solid in December:
I think we are at or nearing the point where auto sales will generally move sideways and thus induce some additional volatility in the headline number. Consequently, it will be increasingly important to focus on core sales ("core" meaning less autos and gas). Looking at the three-month change, we see a modest acceleration in the back half of 2013:
Likewise, industrial production accelerated in the final months of 2013:
The initial read on consumer sentiment was modestly disappointing but not a cause for worry. In general, consumer sentiment has been weaker than what would be suggested by the pace of spending since the recovery began:
Housing starts stumbled in December after surging the previous month:
Housing activity continues to grind higher, with plenty of room left to climb. Increasingly, the gains seem likely to be coming from the single family side of the equation; multifamily has already experienced a solid rebound:
None of the above is meant to imply that we are experiencing runaway growth. Instead, the Beige Book probably sets the right tenor:
Reports from the twelve Federal Reserve Districts suggest economic activity continued to expand across most regions and sectors from late November through the end of the year. Nine Districts indicated the local economy was expanding at a moderate pace; among these, the Atlanta and Chicago Districts saw conditions improve compared with the previous reporting period. Boston and Philadelphia cited modest growth, while Kansas City reported the economy held steady in December. The economic outlook is positive in most Districts, with some reports citing expectations of "more of the same" and some expecting a pickup in growth.
The JOLTS report showed an uptick in the quits rate, something that will likely warm the heart of incoming Federal Reserve Chair Janet Yellen:
It's another quadrant of that chart that is showing improvement, which probably gives Fed officials confidence that they are moving in the right direction by slowly ending the asset purchase program. That said, inflation prevents the Fed from putting their foot on the brakes:
Until we see meaningfully higher inflation numbers, the Fed will be hesitant to deviate from their current expected rate trajectory. Putting aside any financial stability concerns, I am thinking the risk is that unemployment drops to closer to 5.5% when inflation starts to pick up, and policymakers respond with a steeper rate increase fearing they are behind the curve.
Dallas Federal Reserve President Richard Fisher offered-up another colorful speech stressing financial stability concerns. He also revealed he wanted to see the Fed cut asset purchases by $20 billion a month:
I was pleased with the decision to finally begin tapering our bond purchases, though I would have preferred to pull back our purchases by double the announced amount. But the important thing for me is that the committee began the process of slowing down the ballooning of our balance sheet, which at year-end exceeded $4 trillion. And we began—and I use that word deliberately, for we have more to do on this front—to clarify our intentions for managing the overnight money rate.
For all the concerns that the hawks will be persistent policy dissenters, Fisher does not appear to be a likely dissent just yet. For him, it is important just to know the program will end this year.
On the other side of the coin is Minneapolis Federal Reserve President Narayana Kocherlakota. In an interview with Robin Harding at the Financial Times, Kocherlakota makes clear his disappointment with the current policy trajectory:
“We’re running the risk of being content with inflation running consistently below our target. That’s inappropriate,” said Narayana Kocherlakota, who votes on Fed monetary policy this year, in an interview with the Financial Times. “Right now we’re sitting with an outlook for inflation that even by 2016 . . . is not getting back to 2 per cent.”
Importantly, he offers an alternative to the defunct Evans rule:
“We would say we intend to keep the Fed funds rate extraordinarily low in that interval between 6.5 and 5.5 per cent as long as the medium-term outlook for inflation stays sufficiently close to 2 per cent,” he said. “I definitely feel it is important to be numerical about it. Words are always subject, I think, to multiple interpretations.”
The idea of an "interval" gives some insight into the general consensus at the Fed. There does not seem to be considerable support for changing the threshold to 5.5%. Kocherlakota knows this and hopes that he can disguise changing the threshold by calling it an interval. But once you cross 6.5%, the idea of an interval is irrelevant. 5.5% becomes the focus, just as if the threshold has been changed.
Moreover, notice also the change in the inflation threshold from 2.5% to "sufficiently close" to 2%. My sense is that such a change would be interpreted hawkishly. But I think also reveals why policymakers are opposed to changing the unemployment threshold. I am thinking that below 6.5% unemployment, they are less willing to tolerate 2.5% inflation because they worry about falling behind the curve.
I think it is easier to see Kocherlakota dissenting than any of the hawks. It is clear that policy is moving fundamentally in the wrong direction in his opinion:
Mr Kocherlakota said he would not refight the Fed’s decision to taper asset purchases by about $10bn a month. “My point is simply we need to do more. If the committee chose to do that through more asset purchases that’d be fine with me. But we have to be doing more.”
The hawks might want a more rapid end to asset purchases, but at least for them policy is heading in the right direction.
San Francisco Federal Reserve President John Williams questioned the role of asset purchases as part of the Federal Reserve toolkit. Victoria McGrane at the Wall Street Journal has the story here. Williams highlights the uncertain impacts of quantitative easing:
Mr. Williams, who has been supportive of the Fed’s three rounds of bond purchases, said the measures “have proven a potent but blunt tool, with uncertain effects on financial markets and the economy.” The Fed’s bond-buying program, also known as quantitative easing, or QE, aims to lower long-term interest rates in hopes that will spur borrowing, hiring and investment.Surveying the body of research on such bond purchases, Mr. Williams found that studies consistently find that the purchases have a significant impact on long-term bond yields but it’s harder to tell if they’re doing much to help the overall economy.“Estimating the effects of large-scale asset purchases on the economy – as opposed to financial markets – is inherently much harder to do and is subject to greater uncertainty,” he said.
WIlliams also acknowledges the difficulties of implementing forward guidance:
“Experience has shown that it is impossible to convey the full reach of factors that influence the future course of policy. As a result, forward guidance ends up being overly simplified and prone to misinterpretation,” Mr. Williams said in his paper. What’s more, markets may not believe promises about policy made several years in advance since the policymakers making those statements could leave, he noted.
Again, isn't the Evans rule something of an oversimplification that has resulted in confusion? Perhaps a simpler target is needed:
A new framework such as nominal GDP-targeting could, in theory, could work better at communicating the Fed’s policy plans than the current approach, he said, but it might have costs as well.
And then comes the third rail of central banking:
Finally, Mr. Williams also said new research should address whether the Fed and other central banks with a 2% inflation target should aim higher. “[D]oes the 2 percent inflation target … provide a sufficient cushion to allow monetary policy to successfully stabilize the economy and inflation in the future?” he asked in his paper.
All of which sums up to: We are still learning from the crisis and thus we will see consideration of even more innovations to central banking going forward.
And last but not least, Federal Reserve Chairman Ben Bernanke made another victory lap at the inaugural event of the new Hutchins Center on Monetary Policy at the Brookings institute (also where Williams presented). For those of you with four hours to set aside, video is here.
Bottom Line: The US economy is grinding forward. Policymakers are generally comfortable with the pace of tapering at $10 billion per meeting. That could be reconsidered if we see sustained weakness in future data, but I don't think that should be the base case. Not everyone is happy at the Fed, however, and arguably the center has shifted toward the hawks as the doves are clearly not pleased that both asset purchases are ending and the Evans rule does not have an heir apparent. I think it is reasonable to believe the primary conflict at the next FOMC meeting is not over asset purchases, but on the communications strategy. The direction and nature of "enhanced forward guidance" is becoming a contentious issue now that the unemployment rate is just a breath away from the 6.5% threshold.
January 15, 2014
Lecture 4 on Thursday 1/16/2014
Brief Outline of Topics Covered in Lecture 4
Chapter 13 Structure of Central Banks and the Federal Reserve System [continued]
Informal Structure of the Federal Reserve System
- How Power Has Been Centralized Over Time
How Independent is the Fed?
Should The Fed Be Independent?
- The Case for Independence
- The Case Against Independence
Chapter 14 Multiple Deposit Creation and the Money Supply Process
Three Players in the Money Supply Process
The Fed’s Balance Sheet
- Liabilities
- Assets
Control of the Monetary Base
- Open Market Operations with Bank
- Open Market Operations with an Individual and shifts between
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, MBn
- Changes in Borrowed Reserves, BR, from the Fed
- Currency and Deposits
Video
Materials related to 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:
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.
January 13, 2014
Lecture 3 on Tuesday 1/14/2014
Brief Outline of Topics Covered in Lecture 3
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 [Probably won't 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
Not yet available
Materials from class:
The Twelve Federal Reserve Districts
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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:
- What are the Fed's objectives, and how is it trying to meet them?
- What's the relationship between the Fed's monetary policy and the fiscal decisions of the Administration and the Congress?
- What is the risk that the Fed's accommodative monetary policy will lead to inflation?
- How does the Fed's monetary policy affect savers and investors?
- 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.
January 12, 2014
January 08, 2014
Lecture 2 on Thursday 1/9/2014
Brief Outline of Topics Covered in Lecture 2
Chapter 2: An Overview of the Financial System (continued)
Structure and Functions of Financial IntermediariesExample to illustrate functions
Chapter 3 What is Money?
Meaning of Money
Functions of MoneyMedium of Exchange
Unit of Account
Store of Value
Evolution of the Payments System
Commodity Money
Partially backed paper money
Full backed paper money
Fiat MoneyMeasuring 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...
January 06, 2014
Lecture 1 on Tuesday 1/7/2014
Brief Outline of Topics Covered in Lecture 1
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?
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 MoneyMedium of Exchange
Unit of Account
Store of Value
Video
Materials from class:
Extra Reading:
A Short History of American Money, From Fur to Fiat, by David Wolman, The Atlantic: What do animal pelts, tobacco, fake wampum, gold, and cotton-paper bank notes have in common? At one point or another, they've all stood for the same thing: U.S. currency.
Before independence, America's disparate colonial economies struggled with a very material financial hang-up: there just wasn't enough money to go around. Colonial governments attempted to solve this problem by using tobacco, nails, and animal pelts for currency, assigning them a set amount of shillings or pennies so that they could intermix with the existing system.
The most successful ad hoc currency was wampum, a particular kind of bead made from the shells of ocean critters. But eventually the value of this currency, like that of other alternative currencies of the day, was undermined by oversupply and counterfeiting. (That's right: counterfeit wampum. They were produced by dyeing like-shaped shells with berry juice, mimicking the purple color of the real thing.)
It was a crew of Puritans from Boston who first put their faith in paper. Initially, the Massachusetts Bay Colony tried to issue colonial coinage. The pieces themselves, struck in 1652, were made from a mash-up of poor-quality silver and were soon outlawed by the Brits. Less than a decade later the colonists tried again. They were forced to, really, because they owed money to the crown to help fund Britain's war against France, yet lacked any currency with which to pay up. They called the paper "bills of credit." The local government essentially said to the people: Here, just use this. It's real money. We'll sort out redeemability later.
There were endless debates, from prairie farmlands to the floor of Congress, about whether this paper was real money or just a smoke-and-mirrors scheme destined to end badly. ...[continue]...
January 05, 2014
Economics 470
Mark Thoma
Office: BRB 3.158
Phone: TBA
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Department of Economics
University of Oregon 1285
Eugene, OR 97403-1285
GTF Info - 470
TA: Yaran Jin
Office: BRB 2.138
Email: [email protected]
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