Economics 470/570 - Monetary Theory and Policy

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.

Federal Reserve District Banks

The Twelve Federal Reserve Districts
Addresses and phone numbers Banks Branches Boston New York Philadelphia Cleveland Richmond Atlanta Chicago St. Louis Minneapolis Kansas City Dallas San Francisco Board

Technology and Class Attendance

This is something I posted last winter:

I posted this on my blog today about posting class material on the web and how that impacts class attendance. I'd be curious to hear your comments (you might be interested in the comments people have left, there are comments here also):

Dual Banking in the U.S.

Banks can be chartered by either federal or state authorities. Why do we have a dual banking system today? Alan Greenspan discussed this topic in a 1998 speech.

Office Hours

In case you didn't get the email I sent to the class, office hours today (Monday 3/20) will be from 1:30-2:30.

UPDATE: On my blog, my sitetracker shows several people in the last hour using Google to search for "monetary shock" and  visiting a post on the dynamic adjustment to monetary shocks.

Given that, I thought I'd define this term:

A real shock is simply a shock to a real variable, real output, real wages, productivity, that sort of thing, with productivity a common choice.

A monetary shock is a shock to the money supply, to nominal prices, to any nominal variable, e.g. the nominal wage.

Material for Monday 3/13/06

Today:

Ritter, Silber, and Udell:  Chapters 25

Mishkin:  Chapter 24

Next Time:

This is a good reference (campus access): Keynesian Macroeconomics without the LM Curve

Federal Funds Rate Probabilities for Future Meetings

These are from David Altig at macroblog and are based on the programs and data given at the end (click on the figures for larger versions). David is part of the research division at the Cleveland Fed. They are the probabilities, based upon futures markets, of rate hikes at the next few FOMC meetings:

macroblog: Funds Rate Probabilities: Locking In 5, By David Altig The big move of the week in the Carlson-Craig-Melick estimates of market expectations for the federal funds rate path was not in the March meeting, where there wasn't much room to move in the first place...

... but in the May meeting, where another 25 basis points is now being priced in the options market as a dead cinch:

Sentiments in the direction of yet another move at the June meeting ran hot and cold over the week:

I'll declare that race wide open.

The usual data...
Download Imp_pdf_slides_for_blog_031006.ppt
Download implied_pdf_march_031006.xls
Download implied_pdf_may_031006.xls
Download implied_pdf_june_031006.xls

... and a new item the menu, the pictures in flash format:
Download Imp_pdf_slides_for_blog_031006.swf

Review Questions Through Week 9

Economics 470/570
Winter 2006
Review Questions Through Week 9
[pdf file.]

Definitions

Consumption, disposable income, MPC and MPS
Investment
Government spending
Aggregate demand or expenditures
Autonomous expenditures
Expenditure multiplier
Autonomous money demand
IS curve
LM curve
Policy effectiveness
Crowding out

Essay

1. Show graphically using a money demand – money supply diagram and explain intuitively how the interest rate changes if (a) the nominal money supply increases, (b) the price level increases, (c) real income increases, and (d) autonomous money demand increases.

2. Derive the LM curve graphically and explain intuitively why the LM curve slopes upward.

3. Explain why the LM curve is vertical when money demand is unaffected by changes in the interest rate (as in the classical model). More generally, show graphically and explain intuitively how the slope of the LM curve changes when the responsiveness of money demand to the interest rate (|L_i|) increases.

4. What factors cause the LM curve to shift? In what direction do they shift the LM curve? Show the shifts graphically using money demand - money supply and LM curve diagrams.

5. Explain why setting income equal to expenditures is equivalent to setting saving equal to investment.

6. What does the 45 degree line diagram show? Show the equilibrium on the 45 degree line diagram and explain how the economy moves to equilibrium if output differs from its equilibrium value. How will the equilibrium level of output change if there is a change in autonomous consumption, investment, government spending, or taxes? Explain. How will income change if the interest rate falls?

7. What is the expenditure multiplier? Why is it useful?

8. Explain why investment is negatively related to the interest rate.

9. Derive the IS curve graphically and explain intuitively why the IS curve slopes downward.

10. Show graphically and explain intuitively how the slope of the IS curve changes when the responsiveness of investment to the interest rate (|I_i|) increases. When is investment more sensitive to changes in the interest rate, at full employment or in a recession? Explain.

11. What factors cause the IS curve to shift? In what direction do they shift the IS curve? Show the shifts graphically using 45 degree line and IS curve diagrams.

12. Show graphically and explain intuitively how an increase in (a) the money supply, and (b) government spending affects income and the interest rate in the IS-LM model.

13. Use the IS-LM model to examine how the relative effectiveness of monetary and fiscal policy changes as investment becomes less sensitive to the interest rate. Explain the result intuitively.

14. Use the IS-LM model to examine how the relative effectiveness of monetary and fiscal policy changes as money demand becomes less sensitive to the interest rate. Explain the result intuitively.

Paul Krugman's Introduction to Keynes' General Theory

I thought some of you might want to read this. It's Paul Krugman's introduction to Keynes' General Theory of Employment, Interest, and Money:

Introduction by Paul Krugman to The General Theory of Employment, Interest, and Money, by John Maynard Keynes

SYNOPSIS:

Introduction

In the spring of 2005 a panel of “conservative scholars and policy leaders” was asked to identify the most dangerous books of the 19th and 20th centuries. You can get a sense of the panel’s leanings by the fact that both Charles Darwin and Betty Friedan ranked high on the list. But The General Theory of Employment, Interest, and Money did very well, too. In fact, John Maynard Keynes beat out V.I. Lenin and Frantz Fanon. Keynes, who declared in the book’s oft-quoted conclusion that “soon or late, it is ideas, not vested interests, which are dangerous for good or evil,” [384] would probably have been pleased.

Over the past 70 years The General Theory has shaped the views even of those who haven’t heard of it, or who believe they disagree with it. A businessman who warns that falling confidence poses risks for the economy is a Keynesian, whether he knows it or not. A politician who promises that his tax cuts will create jobs by putting spending money in peoples’ pockets is a Keynesian, even if he claims to abhor the doctrine. Even self-proclaimed supply-side economists, who claim to have refuted Keynes, fall back on unmistakably Keynesian stories to explain why the economy turned down in a given year.

In this introduction I’ll address five issues concerning The General Theory. First is the book’s message – something that ought to be clear from the book itself, but which has often been obscured by those who project their fears or hopes onto Keynes. Second is the question of how Keynes did it: why did he succeed, where others had failed, in convincing the world to accept economic heresy? Third is the question of how much of The General Theory remains in today’s macroeconomics: are we all Keynesians now, or have we either superseded Keynes’s legacy, or, some say, betrayed it? Fourth is the question of what Keynes missed, and why. Finally, I’ll talk about how Keynes changed economics, and the world.

Material for Wednesday 3/8/06

Today:

Ritter, Silber, and Udell:  Finish chapters 23, 24

Mishkin:  Finiah chapter 23

Next Time:

Ritter, Silber, and Udell:  Chapters 25

Mishkin:  Chapter 24

Inflation Fighting Credentials

I hear a lot about Bernanke needing to establish his inflation fighting credentials, something I don't think is necessary, but others apparently do. So I was curious to see how Greenspan fared in this regard in comparison.

Midterm 2 Solution

Midterm and Solution.

Material for Monday 3/6/06

Today:

Ritter, Silber, and Udell:  Continue chapters 23, 24

Mishkin:  Continue chapter 23

Next Time:

Ritter, Silber, and Udell:  Finish chapters 23, 24

Mishkin:  Finish chapter 23

Grade Distribution through Midterm 2

Here is the grade distribution through midterm 2. It is based upon the average of the two scores:

Undergrad			Grad
95	A		95	A
95	A		93	A
95	A		89	A-
93	A		86	B
93	A		80	B-
92	A-
91	A-
90	A-
90	A-
89	A-
89	A-
89	A-
88	B+
88	B+
87	B+
86	B+
83	B
82	B
81	B-
80	B-
79	B-
79	B-
78	C+
77	C+
76	C+
74	C
73	C
73	C
72	C
71	C
69	C-
69	C-
67	C-
67	C-
63	D
61	D
60	D
58	F
51	F

Regulatory Relief for Banking Organizations

Today, Federal Reserve Governor Donald Kohn testified before the Committee on Banking, Housing, and Urban Affairs in the Senate on regulatory relief proposals for banking organizations the Fed would like to see implemented. Here are four of the thirty six proposals: 

Appendix: Regulatory Relief, Proposals Supported by the Board of Governors of the Federal Reserve System, Testimony of Donald Kohn: The Board believes the first 20 items listed below would provide meaningful regulatory relief to banking organizations within the jurisdiction of the Federal Reserve. The remaining 16 items would improve the supervision of banking organizations, facilitate the resolution of failed banks, streamline procedural or other requirements under the federal banking laws, or eliminate outdated provisions of law.

1. Authorize the Federal Reserve to pay interest on balances held at Reserve Banks ...gives the Federal Reserve explicit authority to pay interest on balances held by depository institutions at the Federal Reserve Banks....
   
2. Authorize depository institutions to pay interest on demand deposits ...repeals the provisions in current law that prohibit depository institutions from paying interest on demand deposits. If adopted, the amendment would allow all depository institutions that have the authority to offer demand deposits to pay interest on those deposits.
   
3. Ease restrictions on interstate branching and mergers in a competitively equitable manner ...authorizes national and state banks to open de novo branches on an interstate basis. Currently, banks may establish de novo branches in a new state only if the state has affirmatively authorized de novo branching. This existing limitation places banks at a disadvantage to federal savings associations ...
   
4. Allow insured banks to engage in interstate merger transactions with savings associations and trust companies ...would allow an insured bank to directly acquire, by merger, an insured savings association or uninsured trust company in a different home state without first converting ... into an insured bank. As under current law, the insured bank would have to be the survivor of the merger.

For me, an interesting feature of this is the following:

Having the authority to pay interest on excess reserves also could help mitigate potential volatility in overnight interest rates. If the Federal Reserve was authorized to pay interest on excess reserves, and did so, the rate paid would act as a minimum for overnight interest rates, because banks generally would not lend to other banks at a lower rate than they could earn by keeping their excess funds at a Reserve Bank. Although the Board sees no need to pay interest on excess reserves in the near future, the ability to do so would be a potentially useful addition to the monetary policy toolkit of the Federal Reserve.

The discussion, discussed previously here, brings up the possibility of a "channel" or "corridor" system for setting the federal funds rate as is currently in place in Canada, Australia, and new Zealand. This system makes open market operations unnecessary and allows the Fed, as proposed elsewhere on the proposed list or regulatory changes, to remove reserve requirements. Currently, the federal funds rate is capped by the discount rate. Since the Fed will lend to banks at the discount rate, no bank would pay a higher rate in the federal funds market so the federal funds rate cannot go any higher than the discount rate. Similarly, with the ability to pay interest on deposits, no bank would lend to another bank at less than the rate the Fed will pay on deposits, so the federal funds rate cannot be lower than this. These two bounds are shown in the figure below (copied from Mishkin's text). Notice that if these bounds are fairly tight, the federal funds rate will be controlled precisely (for more on this point, see Woodford). In addition, keeping the federal funds rate on target does not require open market operations, only discount window (lombard facility) borrowing and lending.

Material for Wednesday 3/1/06

Today:

Ritter, Silber, and Udell:  Chapters 23, 24

Mishkin:  Chapter 23

Next Time:

Ritter, Silber, and Udell:  Continue chapters 23, 24

Mishkin:  Continue chapter 23

Material for Monday 2/27/06

Today:

Midterm

Next Time:

Ritter, Silber, and Udell:  Chapters 23, 24

Mishkin:  Chapter 23

Review for Midterm 2

Economics 470/570
Winter 2006
Review Questions
[pdf file.]

Definitions

Monetary Base
Borrowed and Non-borrowed reserves
Operating and intermediate targets
Monetary Policy Goals
Defensive and Dynamic Open Market Operations
Primary, Secondary, and Seasonal Credit
Monetary aggregate
Velocity of money
Output gap
Potential output
Natural rate of output
Explain Poole's rules.
Liquidity preference

Essay

1. Derive the deposit and money multipliers when people hold currency and when banks hold excess reserves. Are the multipliers larger or smaller than the simple multiplier, i.e. when currency held and excess reserves are both zero? Explain.

2. Suppose that the required reserve ratio is 20%, the currency to deposit ratio is .25, the excess reserve to deposit ratio is .05, and the monetary base is 1,000. (a) Find the money supply. (b) Let open market operations increase the monetary base by 200. Use the money multiplier to find the new value of the money supply.

3. Using t-accounts, show that the Fed can increase the monetary base by (a) making discount loans to banks, (b) an open market purchase of government bonds from banks, or (c) an open market purchase of government bonds from an individual.

4. (a) Explain why the demand curve for reserves slopes downward. (b) Explain the shape of the supply curve for reserves.

5. Show that the Fed cannot simultaneously control bank reserves and the federal funds rate and therefore cannot adopt both as operating targets.

6. Explain how and why the money multiplier changes when (a) the required reserve ratio increases, (b) the currency to demand deposit ratio increases, and (c) the excess reserve to demand deposit ratio increases. Who determines each of these quantities?

7. What is meant by the phrase lender of last resort? Why is this important? Explain and show graphically how the Fed uses discount rate policy to act as a lender of last resort and how this limits the amount the federal funds rate can rise.

8. Describe the three tools available to the Fed for controlling the money supply. How do defensive and dynamic open-market operations differ? How do primary, seasonal, and secondary credit differ? What are the advantages and disadvantages of each tool?

9. What are the tools, operating targets, intermediate targets, and goals of Federal Reserve Policy? How are they related?

10. Show that if the Fed controls either the federal funds rate or bank reserves, then the variance of the other variable increases.

11. Can the Fed control bank reserves exactly? Explain. Why is this important?

12. Explain the reasons for the Fed’s decision to adopt an interest rate target rather than a monetary aggregate target.

13. Explain Poole's rules.

14. What is the Taylor rule? How is it used? How well does it predict Fed policy?

15. What is the role of money in the classical model?

16. Represent the classical model using an AD-AS diagram and show that changes in money, government spending, and taxes do not affect real output. What is the AD curve in the classical model?

17. State Say’s law. What is the significance of this in terms of government stabilization policy? Explain why Malthus does not believe in Say’s law. How does classical interest theory answer address Malthus’ criticism of Say’s law?

18. Explain classical interest theory. Be sure to explain why the investment function slopes downward and the saving function slopes upward.

19. Explain the quantity theory of money. Explain the Cambridge approach and illustrate that it leads to the same identity as the quantity theory. What assumptions are imposed to arrive at a theoretical statement?

20. What is the money demand function in the classical model?

21. Discuss the transactions, precautionary, and speculative motives for holding money in Keynes liquidity preference theory. When all three motives are put together, what theory of money demand emerges?

22. According to Baumol, the transactions demand for money depends upon the interest rate as well as nominal income. Explain why the transactions demand for money depends upon the interest rate. Why is this important?

Vice Chairman Ferguson Resigns from Board of Governors

This is a surprise[originally here]:

For immediate release: Roger W. Ferguson, Jr., submitted his resignation Wednesday as Vice Chairman and as a member of the Board of Governors of the Federal Reserve System, effective April 28, 2006. ... He will not attend the March 27-28 meeting of the Federal Open Market Committee. ... Ferguson, 54, was first appointed to the Board by President Clinton to fill an unexpired term ending January 31, 2000. He was then appointed by President Bush to a full term that expires on January 31, 2014. ...

Ferguson is the only Democrat on the Board and his departure will give president Bush the opportunity to appoint all seven Board members. That is not how it was intended to work. One possible hint about the resignation comes from Bloomberg:

The vice chairman had been publicly at odds with Bernanke on announcing a numerical inflation target. Bernanke described such a goal at his Nov. 15 confirmation hearing as a "possible step toward greater transparency.''

Ferguson said in October 2004 that an inflation goal may limit the Fed's flexibility to respond to economic shocks, and two months ago said any progress toward such a change "would be very slow.'' Edward Gramlich, who resigned as a Fed governor last year, has said their disagreement "never got acrimonious.''

But I'm hesitant to jump to any conclusions on the reasons for the resignation until we know more. Here's the letter:

Material for Wednesday 2/22/06

Today:

Ritter, Silber, and Udell:  Finish chapter 22.

Mishkin:  Finish chapter 22.

Next Time:

Midterm

FOMC Meeting Minutes Leave Room for More Rate Hikes

The Fed released its minutes from the last FOMC meeting. No surprises. While rates are nearing their destination, the committee expresses more worry about the inflation risk than the risk to output growth and is poised to raise rates again if needed. The bias is toward further rate increases, but all members agree that the next move is far more data dependent than other recent moves [originally here]:

Minutes of the Federal Open Market Committee January 31, 2006: ...The information reviewed at this meeting suggested that underlying growth in aggregate demand remained solid, even though the expansion of real GDP was estimated to have slowed in the fourth quarter. ... Headline consumer inflation had been held down by falling consumer energy prices; more recently, however, crude oil prices climbed back up to high levels. Meanwhile, core inflation had moved up a bit from low levels seen last summer. ...

Material for Monday 2/20/06

Today:

Ritter, Silber, and Udell:  Begin chapter 22.

Mishkin:  Begin chapter 22.

Next Time:

Ritter, Silber, and Udell:  Finish chapter 22.

Mishkin:  Finish chapter 22.

Review for Final

UPDATE: PDF File of This Entire Post

Economics 470/570
Winter 2006
Review Questions - Midterm 1
[pdf file]

Definitions

Medium of exchange/Double coincidence of wants
Unit of account/Multiplicity of prices
Store of value/Liquidity
Financial intermediary
Direct and indirect finance
Liquidity
FOMC
FAC
Discount window
Discount rate
Member bank
Federal Funds rate

Essay

1. How is money measured? Why is there more than one definition of the money supply?

2. What are the functions of money, i.e. why does money exist? Relative to a barter economy, what problems are overcome by the use of money?

3. Describe the evolution of money from barter to fiat money.

4. Describe the main function of financial markets. Explain how direct finance and indirect finance differ.

5. How do financial intermediaries, through their ability to pool resources promote more efficient use of financial resources? Be sure to cover risk pooling, the pooling of small investors, and pooling over time in your answer.

6. How do financial intermediaries reduce default risk, transactions costs, and matching costs?

7. Briefly describe the major functions of Federal Reserve district banks.

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

9. Describe the structure of Federal Reserve districts and Federal Reserve banks.

10. Describe the structure and function of the Board of Governors of the Federal Reserve System.

11. How has the power structure of the Federal Reserve System shifted over time?

12. How independent is the Fed? What factors contribute to independence? What factors work against independence? Discuss arguments for and against the independence of the Fed (we will discuss this question next class).

Economics 470/570
Winter 2006
Review Questions - Midterm 2
[pdf file.]

Definitions

Monetary Base
Borrowed and Non-borrowed reserves
Operating and intermediate targets
Monetary Policy Goals
Defensive and Dynamic Open Market Operations
Primary, Secondary, and Seasonal Credit
Monetary aggregate
Velocity of money
Output gap
Potential output
Natural rate of output
Explain Poole's rules.
Liquidity preference

Essay

1. Derive the deposit and money multipliers when people hold currency and when banks hold excess reserves. Are the multipliers larger or smaller than the simple multiplier, i.e. when currency held and excess reserves are both zero? Explain.

2. Suppose that the required reserve ratio is 20%, the currency to deposit ratio is .25, the excess reserve to deposit ratio is .05, and the monetary base is 1,000. (a) Find the money supply. (b) Let open market operations increase the monetary base by 200. Use the money multiplier to find the new value of the money supply.

3. Using t-accounts, show that the Fed can increase the monetary base by (a) making discount loans to banks, (b) an open market purchase of government bonds from banks, or (c) an open market purchase of government bonds from an individual.

4. (a) Explain why the demand curve for reserves slopes downward. (b) Explain the shape of the supply curve for reserves.

5. Show that the Fed cannot simultaneously control bank reserves and the federal funds rate and therefore cannot adopt both as operating targets.

6. Explain how and why the money multiplier changes when (a) the required reserve ratio increases, (b) the currency to demand deposit ratio increases, and (c) the excess reserve to demand deposit ratio increases. Who determines each of these quantities?

7. What is meant by the phrase lender of last resort? Why is this important? Explain and show graphically how the Fed uses discount rate policy to act as a lender of last resort and how this limits the amount the federal funds rate can rise.

8. Describe the three tools available to the Fed for controlling the money supply. How do defensive and dynamic open-market operations differ? How do primary, seasonal, and secondary credit differ? What are the advantages and disadvantages of each tool?

9. What are the tools, operating targets, intermediate targets, and goals of Federal Reserve Policy? How are they related?

10. Show that if the Fed controls either the federal funds rate or bank reserves, then the variance of the other variable increases.

11. Can the Fed control bank reserves exactly? Explain. Why is this important?

12. Explain the reasons for the Fed’s decision to adopt an interest rate target rather than a monetary aggregate target.

13. Explain Poole's rules.

14. What is the Taylor rule? How is it used? How well does it predict Fed policy?

15. What is the role of money in the classical model?

16. Represent the classical model using an AD-AS diagram and show that changes in money, government spending, and taxes do not affect real output. What is the AD curve in the classical model?

17. State Say’s law. What is the significance of this in terms of government stabilization policy? Explain why Malthus does not believe in Say’s law. How does classical interest theory answer address Malthus’ criticism of Say’s law?

18. Explain classical interest theory. Be sure to explain why the investment function slopes downward and the saving function slopes upward.

19. Explain the quantity theory of money. Explain the Cambridge approach and illustrate that it leads to the same identity as the quantity theory. What assumptions are imposed to arrive at a theoretical statement?

20. What is the money demand function in the classical model?

21. Discuss the transactions, precautionary, and speculative motives for holding money in Keynes liquidity preference theory. When all three motives are put together, what theory of money demand emerges?

22. According to Baumol, the transactions demand for money depends upon the interest rate as well as nominal income. Explain why the transactions demand for money depends upon the interest rate. Why is this important?

Economics 470/570
Winter 2006
Review Questions Through Week 9
[pdf file.]

Definitions

Consumption, disposable income, MPC and MPS
Investment
Government spending
Aggregate demand or expenditures
Autonomous expenditures
Expenditure multiplier
Autonomous money demand
IS curve
LM curve
Policy effectiveness
Crowding out

Essay

1. Show graphically using a money demand – money supply diagram and explain intuitively how the interest rate changes if (a) the nominal money supply increases, (b) the price level increases, (c) real income increases, and (d) autonomous money demand increases.

2. Derive the LM curve graphically and explain intuitively why the LM curve slopes upward.

3. Explain why the LM curve is vertical when money demand is unaffected by changes in the interest rate (as in the classical model). More generally, show graphically and explain intuitively how the slope of the LM curve changes when the responsiveness of money demand to the interest rate (|L_i|) increases.

4. What factors cause the LM curve to shift? In what direction do they shift the LM curve? Show the shifts graphically using money demand - money supply and LM curve diagrams.

5. Explain why setting income equal to expenditures is equivalent to setting saving equal to investment.

6. What does the 45 degree line diagram show? Show the equilibrium on the 45 degree line diagram and explain how the economy moves to equilibrium if output differs from its equilibrium value. How will the equilibrium level of output change if there is a change in autonomous consumption, investment, government spending, or taxes? Explain. How will income change if the interest rate falls?

7. What is the expenditure multiplier? Why is it useful?

8. Explain why investment is negatively related to the interest rate.

9. Derive the IS curve graphically and explain intuitively why the IS curve slopes downward.

10. Show graphically and explain intuitively how the slope of the IS curve changes when the responsiveness of investment to the interest rate (|I_i|) increases. When is investment more sensitive to changes in the interest rate, at full employment or in a recession? Explain.

11. What factors cause the IS curve to shift? In what direction do they shift the IS curve? Show the shifts graphically using 45 degree line and IS curve diagrams.

12. Show graphically and explain intuitively how an increase in (a) the money supply, and (b) government spending affects income and the interest rate in the IS-LM model.

13. Use the IS-LM model to examine how the relative effectiveness of monetary and fiscal policy changes as investment becomes less sensitive to the interest rate. Explain the result intuitively.

14. Use the IS-LM model to examine how the relative effectiveness of monetary and fiscal policy changes as money demand becomes less sensitive to the interest rate. Explain the result intuitively.

Economics 470/570
Winter 2006
Review Questions for Week 10
[pdf file.]

Definitions

Liquidity trap
Monetary shock
SRAS
Full employment
Wealth effect
Real shock
LRAS
Taylor rule
MP curve

Essay

1. Use the IS-LM model to show and explain how price adjustments return the economy to full employment when output differs from its full employment level.

2. Use the AD-AS model to show the SR and LR adjustment to AD shocks in the presence of frictions such as rigid wages.

3. What is a liquidity trap and how does it arise? Explain your answer intuitively and graphically. Is the economy more likely to be in a liquidity trap near full employment or in a recession? Explain.

4. Explain and show graphically using the IS-LM model how the economy can become stuck in a liquidity trap with output less than its full employment level. How can wealth effects overcome this problem?

5. Explain and show graphically using the IS-LM model that when investment is highly insensitive to changes in interest rates, the automatic adjustment mechanism that returns the economy to full employment can break down.

6. In the Keynesian liquidity trap version of the IS-LM model, show that, when the economy is in the liquidity trap, (a) monetary policy is ineffective, and (b) fiscal policy is fully effective.

7. What is the Taylor rule? What are the issues involved in its implementation?

8. Explain why the MP curve slopes upward.

9. Use the IS-MP model to examine the effects of an increase in government spending on output, the real interest rate, consumption, and investment.

10. Use the IS-MP model to examine the effects of tighter monetary policy on output, the real interest rate, consumption, and investment.

11. Use the IS-MP model to examine the effects of a fall in consumer confidence on output, the real interest rate, consumption, and investment.

12. Explain why the SRAS curve shifts upward when output exceeds the natural rate and downward when output is below the natural rate.

13. Derive the AD curve from the IS-MP diagram and explain why it slopes downward.

14. Use the IS-MP and AD-AS diagrams to examine the impact and long-run effects of an increase in government spending or a decrease in taxes on output, inflation, the real interest rate, consumption, and investment.

15. Use the IS-MP and AD-AS diagrams to examine the impact and long-run effects of tighter monetary policy on output, inflation, the real interest rate, consumption, and investment.

Review Questions

Economics 470/570
Winter 2006
Review Questions
[pdf file.]

Definitions

Monetary Base
Borrowed and Non-borrowed reserves
Operating and intermediate targets
Monetary Policy Goals
Defensive and Dynamic Open Market Operations
Primary, Secondary, and Seasonal Credit
Monetary aggregate
Velocity of money
Output gap

Essay

1. Derive the deposit and money multipliers when people hold currency and when banks hold excess reserves. Are the multipliers larger or smaller than the simple multiplier, i.e. when currency held and excess reserves are both zero? Explain.

2. Suppose that the required reserve ratio is 20%, the currency to deposit ratio is .25, the excess reserve to deposit ratio is .05, and the monetary base is 1,000. (a) Find the money supply. (b) Let open market operations increase the monetary base by 200. Use the money multiplier to find the new value of the money supply.

3. Using t-accounts, show that the Fed can increase the monetary base by (a) making discount loans to banks, (b) an open market purchase of government bonds from banks, or (c) an open market purchase of government bonds from an individual.

4. (a) Explain why the demand curve for reserves slopes downward. (b) Explain the shape of the supply curve for reserves.

5. Show that the Fed cannot simultaneously control bank reserves and the federal funds rate and therefore cannot adopt both as operating targets.

6. Explain how and why the money multiplier changes when (a) the required reserve ratio increases, (b) the currency to demand deposit ratio increases, and (c) the excess reserve to demand deposit ratio increases. Who determines each of these quantities?

7. What is meant by the phrase lender of last resort? Why is this important? Explain and show graphically how the Fed uses discount rate policy to act as a lender of last resort and how this limits the amount the federal funds rate can rise.

8. Describe the three tools available to the Fed for controlling the money supply. How do defensive and dynamic open-market operations differ? How do primary, seasonal, and secondary credit differ? What are the advantages and disadvantages of each tool?

9. What are the tools, operating targets, intermediate targets, and goals of Federal Reserve Policy? How are they related?

10. Show that if the Fed controls either the federal funds rate or bank reserves, then the variance of the other variable increases.

11. Can the Fed control bank reserves exactly? Explain. Why is this important?

12. Explain the reasons for the Fed’s decision to adopt an interest rate target rather than a monetary aggregate target.

Material for Wednesday 2/15/06

Today:

Ritter, Silber, and Udell:  Finish chapter 19, 21.

Mishkin:  Finish chapter16, 17.

Next Time:

Ritter, Silber, and Udell:  Chapter 22.

Mishkin:  Chapter 22.

FF Market Graphs

Response to an Open Market Operation



Response to a Change in the Discount Rate - No Discount Lending



Response to a Change in the Discount Rate - Some Discount Lending



Response to a Change in Required Reserves

For more, see Mishkin, pages 393-398.

Material for Monday 2/13/06

Today:

Ritter, Silber, and Udell:  Finish chapter 19, 21.

Mishkin:  Finish chapter16, 17.

Next Time:

Ritter, Silber, and Udell:  Chapter 22.

Mishkin:  Chapter 22.

Midterm 1 Solution

Midterm and Solution.

Material for Wednesday 2/8/06

Today:

Ritter, Silber, and Udell:  Finish chapter 19, 21.

Mishkin:  Finish chapter16, 17.

Next Time:

Ritter, Silber, and Udell:  Chapter 22.

Mishkin:  Chapter 22.

WSJ Econoblog: Stitching a New Safety Net

Andrew Samwick of Dartmouth (in 2003 and 2004, he served as the chief economist on the staff of the President's Council of Economic Advisers) and I just finished an Econoblog for the Wall Street Journal Online. The issue we were asked to address is:

WSJ Econoblog: Stitching a New Safety Net: For many years, workers could manage their medical expenses with employer-provided health insurance and Medicare and look forward to underwriting their golden years with payments from a defined-benefit pension and Social Security.

But the landscape of social insurance is shifting. Many large corporations are moving their employees from traditional pensions to riskier 401(k)s and asking workers to pay more out of their own pockets for health insurance. At the same time, Social Security and Medicare, the two venerable entitlement programs, are facing growing demographic strains as the vast baby boom generation reaches retirement age.

The Wall Street Journal Online asked economist bloggers Mark Thoma and Andrew Samwick to explore how we how arrived at this point and discuss what workers and retirees might expect in the future, as the composition of the social safety net continues to shift.

Here's the free link once again. And thanks to Andrew for an enjoyable discussion. [Originally posted here]

Material for Monday 2/6/06

Today:

Midterm

Next Time:

Ritter, Silber, and Udell:  Chapter 19.

Mishkin:  Chapter 16.

Material for Wednesday 2/1/06

Today:

Ritter, Silber, and Udell:  Chapter 18.

Mishkin:  Chapter 15.

Next Time:

Midterm

Review Questions for Exam

Economics 470/570
Winter 2006
Review Questions for Exam
[PDF FILE]

Definitions

Medium of exchange/Double coincidence of wants
Unit of account/Multiplicity of prices
Store of value/Liquidity
Financial intermediary
Direct and indirect finance
Liquidity
FOMC
FAC
Discount window
Discount rate
Member bank
Federal Funds rate
Asset
Liability
Demand Deposit
Bank Reserves
Reserve Requirement
Required Reserves
Excess Reserves

Essay

1. How is money measured? Why is there more than one definition of the money supply?

2. What are the functions of money, i.e. why does money exist? Relative to a barter economy, what problems are overcome by the use of money?

3. Describe the evolution of money from barter to fiat money.

4. Describe the main function of financial markets. Explain how direct finance and indirect finance differ.

5. How do financial intermediaries, through their ability to pool resources promote more efficient use of financial resources? Be sure to cover risk pooling, the pooling of small investors, and pooling over time in your answer.

6. How do financial intermediaries reduce default risk, transactions costs, and matching costs?

7. Briefly describe the major functions of Federal Reserve district banks.

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

9. Describe the structure of Federal Reserve districts and Federal Reserve banks.

10. Describe the structure and function of the Board of Governors of the Federal Reserve System.

11. How has the power structure of the Federal Reserve System shifted over time?

12. How independent is the Fed? What factors contribute to independence? What factors work against independence? Discuss arguments for and against the independence of the Fed.

13. Write down the government budget constraint and explain each term.

14. Why is a demand deposit an asset for an individual, but a liability of the bank?

15. Show the t-accounts and the balance sheet for the following series of transactions. 

(i) Open a bank with 10 million dollars, put 3 million into buildings and equipment.

(ii) Put 2 million of the cash into T-bills.

(iii) Deposit 1.5 million into regional Fed bank.

(iv) Collect 4 million in deposits from other banks.

(v) Let the required reserve ratio be 20% and show what happens if the bank loans out all excess reserves.

16. Suppose that a bank has $100,000 in excess reserves. Assuming that the required reserve ratio is 20%, use t-accounts to illustrate the multiple deposit creation process. Use this to obtain the simple deposit multiplier. Why are the deposit multiplier and the money multiplier the same when there is no currency and when banks loan out all excess reserves?

17. Suppose that the required reserve ratio is 20%, and the monetary base is 1,000. (a) Find the money supply. (b) Let open market operations increase the monetary base by 200. Use the money multiplier to find the new value of the money supply. [Update: This question had a mistake in it - we hadn't covered excess reserves and currency as part of the multiplier yet. It's been fixed.]

Past Midterms and Finals Posted

I posted old midterms and finals from 1995-2004. The years 2001 and 2002 are missing as I was away those years.

Click on either "Midterms" or "Finals" on the sidebar to access them.

Material for Monday 1/30/06

Today:

Ritter, Silber, and Udell:  Finished chapter 17.

Mishkin:  Finished chapter 14.

Next Time:

Ritter, Silber, and Udell:  Begin chapter 18.

Mishkin:  Begin chapter 15.

Bush is Moving to Fill Two Slots at the Federal Reserve

As we just talked about this in class, I thought I'd pass along news from Greg Ip and John McKinnon at the Wall Street Journal on Bush's choice to fill the two open seats on the Federal Reserve Board of Governors [posted here]:

Bush Is Moving To Fill Two Slots At Federal Reserve, by Greg Ip and John D. McKinnon, WSJ: With leadership at the Federal Reserve about to change, the White House is moving to fill two vacancies on the central bank's seven-member board of governors. President Bush plans to soon nominate Kevin M. Warsh, a White House adviser on domestic finance and capital markets, to fill one of the two vacancies, two people familiar with the matter said. Mr. Bush aims to fill the other seat with an academic economist, and the likeliest candidate is Randall S. Kroszner, who teaches at the University of Chicago's Graduate School of Business, one of these people said...

The nominations would tilt the board's composition toward financial-industry expertise rather than macroeconomics. Mr. Warsh, a lawyer by training, was an investment banker at Morgan Stanley before joining the White House National Economic Council. He has been the White House's point person on financial-industry issues. Mr. Kroszner, who served on the Council of Economic Advisers during Mr. Bush's first term, specializes in banking, banking regulation, international-financial crises and monetary economics...

From Brad DeLong on Richard Kroszner:

I know I'm proud to have played a (alas, very small) part in the education of Randy Kroszner and Robin Hanson, both far to my right.

From Institutional Economics:

Both Clarida and Kroszner would be excellent appointments.  Appointing non-specialists with financial market backgrounds would be a mistake in my view, increasing the risk of ... regulatory capture by Wall Street...

That doesn't sound like a strong endorsement of Warsh. I know little about him. BusinessWeek Online has a bit more, but not much:

Warsh is the NEC's point man for contact with the financial-services industry. He has recently sought to raise his public profile by speaking to more industry groups and was mentioned as a candidate for chairman of the Securities & Exchange Commission before Bush tapped Rep. Christopher Cox (R-Calif.) for the job.

Material for Wednesday 1/25/06

Today:

Ritter, Silber, and Udell:  Chapter 17 through page 343.

Mishkin:  Chapter 14 through page 349.

Next Time:

Ritter, Silber, and Udell:  Finish chapter 17, begin chapter 18.

Finish chapter 14, begin chapter 15.

Review Questions

Economics 470/570
Winter 2006
Review Questions - Midterm 1
[pdf file]

Definitions

Medium of exchange/Double coincidence of wants
Unit of account/Multiplicity of prices
Store of value/Liquidity
Financial intermediary
Direct and indirect finance
Liquidity
FOMC
FAC
Discount window
Discount rate
Member bank
Federal Funds rate

Essay

1. How is money measured? Why is there more than one definition of the money supply?

2. What are the functions of money, i.e. why does money exist? Relative to a barter economy, what problems are overcome by the use of money?

3. Describe the evolution of money from barter to fiat money.

4. Describe the main function of financial markets. Explain how direct finance and indirect finance differ.

5. How do financial intermediaries, through their ability to pool resources promote more efficient use of financial resources? Be sure to cover risk pooling, the pooling of small investors, and pooling over time in your answer.

6. How do financial intermediaries reduce default risk, transactions costs, and matching costs?

7. Briefly describe the major functions of Federal Reserve district banks.

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

9. Describe the structure of Federal Reserve districts and Federal Reserve banks.

10. Describe the structure and function of the Board of Governors of the Federal Reserve System.

11. How has the power structure of the Federal Reserve System shifted over time?

12. How independent is the Fed? What factors contribute to independence? What factors work against independence? Discuss arguments for and against the independence of the Fed (we will discuss this question next class).

Economics 470/570
Winter 2006
Review Questions - Midterm 2
[pdf file.]

Definitions

Monetary Base
Borrowed and Non-borrowed reserves
Operating and intermediate targets
Monetary Policy Goals
Defensive and Dynamic Open Market Operations
Primary, Secondary, and Seasonal Credit
Monetary aggregate
Velocity of money
Output gap
Potential output
Natural rate of output
Explain Poole's rules.
Liquidity preference

Essay

1. Derive the deposit and money multipliers when people hold currency and when banks hold excess reserves. Are the multipliers larger or smaller than the simple multiplier, i.e. when currency held and excess reserves are both zero? Explain.

2. Suppose that the required reserve ratio is 20%, the currency to deposit ratio is .25, the excess reserve to deposit ratio is .05, and the monetary base is 1,000. (a) Find the money supply. (b) Let open market operations increase the monetary base by 200. Use the money multiplier to find the new value of the money supply.

3. Using t-accounts, show that the Fed can increase the monetary base by (a) making discount loans to banks, (b) an open market purchase of government bonds from banks, or (c) an open market purchase of government bonds from an individual.

4. (a) Explain why the demand curve for reserves slopes downward. (b) Explain the shape of the supply curve for reserves.

5. Show that the Fed cannot simultaneously control bank reserves and the federal funds rate and therefore cannot adopt both as operating targets.

6. Explain how and why the money multiplier changes when (a) the required reserve ratio increases, (b) the currency to demand deposit ratio increases, and (c) the excess reserve to demand deposit ratio increases. Who determines each of these quantities?

7. What is meant by the phrase lender of last resort? Why is this important? Explain and show graphically how the Fed uses discount rate policy to act as a lender of last resort and how this limits the amount the federal funds rate can rise.

8. Describe the three tools available to the Fed for controlling the money supply. How do defensive and dynamic open-market operations differ? How do primary, seasonal, and secondary credit differ? What are the advantages and disadvantages of each tool?

9. What are the tools, operating targets, intermediate targets, and goals of Federal Reserve Policy? How are they related?

10. Show that if the Fed controls either the federal funds rate or bank reserves, then the variance of the other variable increases.

11. Can the Fed control bank reserves exactly? Explain. Why is this important?

12. Explain the reasons for the Fed’s decision to adopt an interest rate target rather than a monetary aggregate target.

13. Explain Poole's rules.

14. What is the Taylor rule? How is it used? How well does it predict Fed policy?

15. What is the role of money in the classical model?

16. Represent the classical model using an AD-AS diagram and show that changes in money, government spending, and taxes do not affect real output. What is the AD curve in the classical model?

17. State Say’s law. What is the significance of this in terms of government stabilization policy? Explain why Malthus does not believe in Say’s law. How does classical interest theory answer address Malthus’ criticism of Say’s law?

18. Explain classical interest theory. Be sure to explain why the investment function slopes downward and the saving function slopes upward.

19. Explain the quantity theory of money. Explain the Cambridge approach and illustrate that it leads to the same identity as the quantity theory. What assumptions are imposed to arrive at a theoretical statement?

20. What is the money demand function in the classical model?

21. Discuss the transactions, precautionary, and speculative motives for holding money in Keynes liquidity preference theory. When all three motives are put together, what theory of money demand emerges?

22. According to Baumol, the transactions demand for money depends upon the interest rate as well as nominal income. Explain why the transactions demand for money depends upon the interest rate. Why is this important?

Economics 470/570
Winter 2006
Review Questions Through Week 9
[pdf file.]

Definitions

Consumption, disposable income, MPC and MPS
Investment
Government spending
Aggregate demand or expenditures
Autonomous expenditures
Expenditure multiplier
Autonomous money demand
IS curve
LM curve
Policy effectiveness
Crowding out

Essay

1. Show graphically using a money demand – money supply diagram and explain intuitively how the interest rate changes if (a) the nominal money supply increases, (b) the price level increases, (c) real income increases, and (d) autonomous money demand increases.

2. Derive the LM curve graphically and explain intuitively why the LM curve slopes upward.

3. Explain why the LM curve is vertical when money demand is unaffected by changes in the interest rate (as in the classical model). More generally, show graphically and explain intuitively how the slope of the LM curve changes when the responsiveness of money demand to the interest rate (|L_i|) increases.

4. What factors cause the LM curve to shift? In what direction do they shift the LM curve? Show the shifts graphically using money demand - money supply and LM curve diagrams.

5. Explain why setting income equal to expenditures is equivalent to setting saving equal to investment.

6. What does the 45 degree line diagram show? Show the equilibrium on the 45 degree line diagram and explain how the economy moves to equilibrium if output differs from its equilibrium value. How will the equilibrium level of output change if there is a change in autonomous consumption, investment, government spending, or taxes? Explain. How will income change if the interest rate falls?

7. What is the expenditure multiplier? Why is it useful?

8. Explain why investment is negatively related to the interest rate.

9. Derive the IS curve graphically and explain intuitively why the IS curve slopes downward.

10. Show graphically and explain intuitively how the slope of the IS curve changes when the responsiveness of investment to the interest rate (|I_i|) increases. When is investment more sensitive to changes in the interest rate, at full employment or in a recession? Explain.

11. What factors cause the IS curve to shift? In what direction do they shift the IS curve? Show the shifts graphically using 45 degree line and IS curve diagrams.

12. Show graphically and explain intuitively how an increase in (a) the money supply, and (b) government spending affects income and the interest rate in the IS-LM model.

13. Use the IS-LM model to examine how the relative effectiveness of monetary and fiscal policy changes as investment becomes less sensitive to the interest rate. Explain the result intuitively.

14. Use the IS-LM model to examine how the relative effectiveness of monetary and fiscal policy changes as money demand becomes less sensitive to the interest rate. Explain the result intuitively.

Economics 470/570
Winter 2006
Review Questions for Week 10
[pdf file.]

Definitions

Liquidity trap
Monetary shock
SRAS
Full employment
Wealth effect
Real shock
LRAS
Taylor rule
MP curve

Essay

1. Use the IS-LM model to show and explain how price adjustments return the economy to full employment when output differs from its full employment level.

2. Use the AD-AS model to show the SR and LR adjustment to AD shocks in the presence of frictions such as rigid wages.

3. What is a liquidity trap and how does it arise? Explain your answer intuitively and graphically. Is the economy more likely to be in a liquidity trap near full employment or in a recession? Explain.

4. Explain and show graphically using the IS-LM model how the economy can become stuck in a liquidity trap with output less than its full employment level. How can wealth effects overcome this problem?

5. Explain and show graphically using the IS-LM model that when investment is highly insensitive to changes in interest rates, the automatic adjustment mechanism that returns the economy to full employment can break down.

6. In the Keynesian liquidity trap version of the IS-LM model, show that, when the economy is in the liquidity trap, (a) monetary policy is ineffective, and (b) fiscal policy is fully effective.

7. What is the Taylor rule? What are the issues involved in its implementation?

8. Explain why the MP curve slopes upward.

9. Use the IS-MP model to examine the effects of an increase in government spending on output, the real interest rate, consumption, and investment.

10. Use the IS-MP model to examine the effects of tighter monetary policy on output, the real interest rate, consumption, and investment.

11. Use the IS-MP model to examine the effects of a fall in consumer confidence on output, the real interest rate, consumption, and investment.

12. Explain why the SRAS curve shifts upward when output exceeds the natural rate and downward when output is below the natural rate.

13. Derive the AD curve from the IS-MP diagram and explain why it slopes downward.

14. Use the IS-MP and AD-AS diagrams to examine the impact and long-run effects of an increase in government spending or a decrease in taxes on output, inflation, the real interest rate, consumption, and investment.

15. Use the IS-MP and AD-AS diagrams to examine the impact and long-run effects of tighter monetary policy on output, inflation, the real interest rate, consumption, and investment.

Material for Monday 1/23/06

Today:

Ritter, Silber, and Udell:  Chapter 4, pgs. 63-64, Chapter 17 through page 339.

Mishkin:  Chapter 4, pgs. 79-82, Chapter 14 through page 339.

Next Time:

Ritter, Silber, and Udell:  Finish chapter 17, begin chapter 18.

Finish chapter 14, begin chapter 15.

Fed Watch: Ready to Invert

Tim Duy with his latest Fed Watch [Originally posted here]:

Financial Market Deregulation Under Greenspan: Did It Go Too Far?

[Originally here.]

Steven Pearlstein of the Washington Post talks about an area of Greenspan's tenure that hasn't received as much press at it might, his penchant for financial deregulation:

The Laissez-Fairest of Them All, by Steven Pearlstein, Washington Post: ...Perhaps Greenspan's most important contribution has been as the policymaker who... engineered the wholesale deregulation of the U.S. banking and financial system. In this respect, his most enduring legacy is an American economy that is not only more prone to assets bubbles, corporate scandal and financial crises, but robust enough to absorb such shocks while continuing to deliver long-term economic growth.

A determination to substitute the wisdom of markets for the heavy hand of government runs through the Greenspan story. ... There was, for example, his work on behalf of Lincoln Savings and Loan seeking permission for thrifts to branch out from boring old home loans to invest directly in commercial real estate ventures. Greenspan told Congress such powers were "essential for the financial stability and survival of the savings and loan industry." Congress agreed, but this first bit of financial deregulation spawned a crisis that nearly wiped out the industry, cost taxpayers more than $100 billion and landed Lincoln's top executive in prison.

Once installed at the Fed, Greenspan immediately began pushing Congress to repeal the Depression-era law that prevented banks from competing with investment banks in underwriting stocks and bonds. When Congress dallied, he used the Fed's supervisory authority to allow banks to circumvent the law and usher in the era of the megabank. ...

When crisis struck, Greenspan was quick on the scene with liquidity to prevent it from spreading. But he almost never saw in such episodes a reason for new regulation. Even after derivatives trading bankrupt Orange County, Calif., and the venerable Barings investment house, Greenspan fought efforts to regulate these newfangled financial instruments. And while the near collapse of Long-Term Capital required the Fed's jawboning to prevent a global financial meltdown, Greenspan opposed efforts by the Securities and Exchange Commission to initiate even modest regulation of the $1 trillion hedge fund industry.

After the Enron scandal, accounting regulators set out to draft rules to prevent companies and their lenders from using "special purpose entities" to hide indebtedness from investors. Objections from the Fed stalled adoption of the new rules, and eventually watered them down. And just yesterday came Greenspan's latest salvo in his campaign to dismantle Fannie Mae and Freddie Mac. In a letter to Sen. John E. Sununu (R-N.H.), he reprises his view that there's nothing the government-sponsored mortgage lenders do that private banks couldn't do at less cost to taxpayers, with less threat to the financial system.

As you can probably tell, I didn't much like most of these decisions. There was, and is, plenty of evidence that skillful regulation and intervention can help deter corporate fraud, protect investors from Wall Street sharpies and reduce the frequency and severity of assets bubbles and financial crises.

At the same time, Greenspan is probably right that deregulation sparked a flurry of financial innovation that has made capital cheaper and more readily available, done a better job of pricing and spreading risk and shielded the economy from the impact of financial crises. ... Greenspan summed up the trade-offs behind his deregulatory philosophy in a series of unusually lucid speeches in London in 2002, on the eve of being knighted by Queen Elizabeth. "The extent of government intervention in markets to control risk-taking," he said, "is a trade-off between economic growth and its associated potential instability, and a more civil but less stressful way of life with a lower standard of living."...

I have the same reaction. Compared to twenty years ago, there has been remarkable transition and innovation in the financial services industry driven by competition. So far, so good. But I also worry that deregulation has gone too far and made us more vulnerable to financial meltdown in the face of large and unexpected shocks. Housing markets are a good example of this. The promotion of home ownership though creative financing allows many to purchase homes that could not have done so not that long ago. But have people taken on excessive risk and thereby increased our vulnerability to a crash?

The Decline in Workplace Provided Health Coverage

[This is about health care coverage, so it's not directly related to monetary policy, but thought it might be of interest ... originally posted here.]

This is from Table 132 of this report from the CDC web site. It's a graph of the percentage of people with workplace provided private health coverage from 1984-2003. There's quite a bit of detail in the table including breakdowns of coverage by age, sex, race, and income level. For example, here's coverage by age:

The numerical overall changes by age are:

Age

	1984	2003	Change
Under 18 years	66.5	58.6	-7.9
18-44 years	69.6	62.2	-7.4
45-64 years	71.8	70.0	-1.8

Thus, the largest decline is for those under 45.

Here are the numerical endpoint data by sex along with the overall changes. Given the standard errors in the table (not shown here), there is little difference between males and females:

Sex

	1984	2003	Change
Male	69.8	63.3	-6.5
Female	68.4	63.3	-5.1

There are, however, big differences by income level, and the changes are larger for those under 18. As the following table shows, the decline in workplace provided health care coverage has been largest among those earning between 100% and 200% of the poverty level, a change of over 20%, while the change for those outside this range is less than 10%:

Age and Percent of Poverty Level

All ages	1984	2003	Change
Below 100 %	24.1	19.9	-4.2
100-149 %	52.4	31.8	-20.6
150-199 %	69.5	46.8	-22.7
200 % or more	85.0	78.6	-6.4
Under 18 years
Below 100 %	23.0	14.0	-9.0
100-149 %	58.3	30.1	-28.2
150-199 %	75.8	47.0	-28.8
200 % or more	86.9	79.9	-7.0

These data show that middle income families have been affected most by the decline in employer provided private health care coverage.

Update: A colleague writes to tell me:

The explanation for the decline in coverage (at least through the late 90s) is also quite interesting.  David Cutler has a paper (NBER WP #9036), arguing that the reason for the decline was not a decrease in employers offering HI, but a decrease in employees choosing to purchase insurance from their employers, primarily due to rising premiums.

New Support for Friedman's Plucking Model

[Something I thought might interest one or two of you ... originally posted here.]

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. Here's a recent paper on this topic that supports the plucking framework (thanks Paul):

Asymmetry in the Business Cycle: New Support for Friedman's Plucking Model, Tara M. Sinclair, George Washington University, December 16, 2005, SSRN: Abstract This paper presents an asymmetric correlated unobserved components model of US GDP. The asymmetry is captured using a version of Friedman's plucking model that suggests that output may be occasionally "plucked" away from a ceiling of maximum feasible output by temporary asymmetric shocks. The estimates suggest that US GDP can be usefully decomposed into a permanent component, a symmetric transitory component, and an additional occasional asymmetric transitory shock. The innovations to the permanent component and the symmetric transitory component are found to be significantly negatively correlated, but the occasional asymmetric transitory shock appears to be uncorrelated with the permanent and symmetric transitory innovations. These results are robust to including a structural break to capture the productivity slowdown of 1973 and to changes in the time frame under analysis. The results suggest that both permanent movements and occasional exogenous asymmetric transitory shocks are important for explaining post-war recessions in the US.

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.

Fed Links

I posted this on my blog tonight:

There were two speeches today by Fed officials. First, there was a speech by Fed Governor Susan Bies:

Productivity and Economic Outlook

Bottom line: Likes current situation, but worried about capacity and resource constraints driving up input prices and causing in inflationary pressure.

There was also a speech by Richmond Fed President Jeffrey M. Lacker:

The Economic Outlook for 2006

Bottom line: Likes current situation, but not sure that the pass-through risk from high energy prices to core inflation is over. One more rate hike, then assess incoming data to see where to go next.

Here's the Bloomberg write-up of the speeches:

Fed Officials See Inflation Risks From Oil, Rising Factory Use

And also from Bloomberg, Gene Sperling assesses Greenspan's record. He has quarrels with particular episodes such as the 2001 tax cut, but overall sees Greenspan's record in a positive light:

Time to Judge the Whole Record of Alan Greenspan

Material for Wednesday 1/18/06

Today:

Ritter, Silber, and Udell:  Chapter 2

Mishkin:  Chapter 3

Next Time:

Ritter, Silber, and Udell:  Chapter 4, pgs. 63-64, Chapter 17

Mishkin:  Chapter 4, pgs. 79-82, Chapter 14

Books on Reserve

Both books are now on reserve.

A Brief History of the U.S. Payments System

Anthony M. Santomero, President of the Philadelphia Fed, discusses the evolution of our payments system.  The history starts at a time in the U.S. when each bank issued its own checks and currency and banks are chartered and regulated by individual states rather than by the federal government.  He talks about some of the problems that arrangement causes for transactions, particularly over long distances, and how the federal government attempts to solve this by introducing a national currency and check clearing system.

The Evolution of Central Banking in the United States

A very nice history of central banking in the United States from Federal Reserve Vice Chairman Roger W. Ferguson, Jr. with comparisons to the introduction of the Euro and the European Central Bank:

The Evolution of Central Banking in the United States, Vice Chairman Roger W. Ferguson, Jr., The European Central Bank, Frankfurt, Germany, April 27, 2005

…I would like to discuss the evolution of central banking in the United States, with particular reference to currency, relations between the regions and the center, mandates, and communication. Along the way, I will compare our experience with that of the ECB…

Material for Wednesday 1/11/06

Today:

We covered this from Mishkin's text.

Next Time:

Ritter, Silber, and Udell:  Chapter 2

Mishkin:  Chapter 3

Reading from Mishkin's Text

Functions of Financial Intermediaries from Mishkin pages 29-32: