Economics 470/570 - Monetary Theory and Policy

Syllabus for Winter 2007

[Syllabus in pdf format]

Monetary Theory and Policy
Course: Economics 470/570
Professor: Mark Thoma
Office/Hours: PLC 471 on M/W 12:00-1:00 p.m.
Phone/Email: (541) 346-4673, [email protected]
Web Page: http://darkwing.uoregon.edu/~mthoma/

Text: Frederic S. Mishkin, The Economics of Money, Banking, and Financial Markets, 7th edition (Addison Wesley: New York).

Prerequisites: Economics 313 or the equivalent.

GTF, Office Hours, Location, and Email Address:

GTF: Beilei Cai
Office: PLC 446
Office Hours: T/Th 1:00-2:00 p.m. and by appointment
[email protected]

Tests and Grading: There will be two midterm exams and a final.  The midterms will be given Wednesday, January 31^st and Monday, February 26^th.  The final will be given on Friday, March 23^rd from 10:15 a.m. – 12:15 p.m.  No make-up exams will be given.  Each midterm is worth 30% and the final is worth 40%.  Grades will be assigned according to your relative standing in the class.

Homework: Problem sets will be assigned periodically. These are not graded, but it is strongly recommended that you do them since exam questions will be based, in part, upon the problem sets.

Course Outline:

Introduction	Mishkin Text
Introduction	Ch. 1, pgs. 8-13
The Role of Money in the Macroeconomy	Ch. 3, Ch. 4 pgs. 87-90
Central Banking and the Conduct of Monetary Policy
Structure of Central Banks and the Federal Reserve System	Ch. 12
Bank Reserves and the Money Supply	Ch. 13
Determinants of the Money Supply	Ch. 14
Tools of Monetary Policy	Ch. 15
Monetary Theory
The Demand for Money	Ch. 19
The Keynesian Framework	Ch. 20
Monetary and Fiscal Policy	Ch. 21
The AS-AD Model	Ch. 22
Money and Inflation	Ch. 24
Rational Expectations: Theory and Policy Implications	Ch. 25

Video Lectures - Winter 2007

Lecture 1 - Chapter 1, pgs. 8-13; Chapter 3, pgs. 49-52

Lecture 1
Google Video

Lecture 2 - Chapter 3, pgs. 53-61; Chapter 4, pgs. 87-90

Lecture 2
Google Video

Lecture 3 - Chapter 12,  pgs. 311-321

Lecture 3
Google Video

Lecture 4 - Chapter 12,  pgs. 321-330; Chapter 13, pgs. 333-340

Lecture 4
Google Video

Lecture 5 - Chapter 13,  pgs. 340-347

Lecture 5
Google Video

Lecture 6 - Chapter 14,  pgs. 351-367; Chapter 15, pgs. 373-389

Lecture 6
Google Video

Lecture 7 - Chapter 19,  pgs. 493-500

Lecture 7
Google Video

Lecture 8 - Chapter 19,  pgs. 501-510

Lecture 8
Google Video

Lecture 9 - Chapter 20,  pgs. 513-531

Lecture 9
Google Video

Lecture 10 - Chapter 20, pgs. 531-535; Chapter 21, pgs. 539-546

Lecture 10
Google Video

Lecture 11 - Chapter 20, pgs. 546-549

Lecture 11
Google Video

Lecture 12 - Chapter 20, pgs. 549-558

Lecture 12
Google Video

Lecture 13 - Chapter 22, pgs. 561-568

Lecture 13
Google Video

Lecture 14 - Chapter 22, pgs. 569-580; Chapter 24, pgs 613-626

Lecture 14
Google Video

Lecture 15 - Chapter 24, pgs. 626-635; Chapter 25, 639-641

Lecture 15
Google Video

Lecture 16 - Chapter 25, pgs. 641-652

Lecture 16
Google Video

Lecture 17 - Chapter 25, pgs. 652-658

Lecture 17
Google Video

Final Exam Winter 2007

Final and Solution.

Review Questions - Material after Midterm 2

Definitions

Potential or natural rate of output
Aggregate Supply
Deficit
Debt
Debt monetization
Inflation
Cost push inflation
Demand pull inflation
Activist/non-activist
Data lag
Recognition lag
Legislative lag
Implementation lag
Effectiveness lag
Policy ineffectiveness proposition
Rational expectations
Natural rate hypothesis

Essay

1. Explain the Monetarist view of aggregate demand. Explain why Monetarists do not believe that shifts in the IS curve affect aggregate demand.

2. Explain the Keynesian view of aggregate demand.

3. Why does the short-run aggregate supply curve slope upward? What factors cause the aggregate supply curve to shift?

4. Is the economy self-correcting?

5. What causes the SRAS curve to shift? Explain.

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

7. Do Monetarists agree with Friedman's contention that inflation is always and everywhere a monetary phenomenon? Explain using the AD-AS model.

8. Do Keynesians agree with Friedman's contention that inflation is always and everywhere a monetary phenomenon? Explain using the AD-AS model.

9. Explain how the pursuit of a high employment target by policymakers can lead to inflation.

10. Can budget deficits lead to inflation? Explain.

11. Why might governments choose to monetize the debt?

12. Explain the activist and non-activist positions on the use of government policy to stabilize macroeconomic variables such as real output. What problems are encountered in the pursuit of activist policies?

13. Explain and give an example of the Lucas critique. Why is this important?

14. What are the essential differences between the Classical, Keynesian, New Classical, and New Keynesian models?

15. Show that it is possible in a model with expectations (e.g. using the New Classical model) for an increase in the money supply to reduce output if the change in the money supply is smaller than expected.

16. Compare and contrast the effects of an unexpected increase or decrease in the money supply on prices and output in the traditional Keynesian, New Classical, and New Keynesian models.

17. Compare and contrast the effects of an expected increase or decrease in the money supply on prices and output in the traditional Keynesian, New Classical, and New Keynesian models.

18. Suppose the monetary authority wants to reduce the inflation rate. Compare the costs (in terms of output) of reducing inflation in the traditional Keynesian, New Classical, and New Keynesian models. Be sure to cover both an expected and an unexpected change in policy. Why is the credibility of policymakers important?

Class Materials for Lecture 17

Brief Outline of Topics Covered in Lecture 17

Chapter 25 Rational Expectations and Implications for Policy

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

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

Materials from class:

Continue with materials posted for lecture 16.

Video:

Lecture 17 - Chapter 25, pgs. 652-658
Google Video

Additional Reading:

• The Changing Dynamics of Inflation
• Students and Faculty Given Free Access to TimesSelect
• Econoblog: Is Democracy the Best Setting For Strong Economic Growth?
• How Productive Are We?
• Inflation and Unemployment II

Application:

This graph is from the San Francisco Fed. It shows the relationship between unemployment and wage inflation:

The accompanying write-up says:

Conventional wisdom holds that when the unemployment rate falls below the NAIRU, wage inflation increases, which eventually feeds through to price inflation. A key question for policymakers is whether this conventional wisdom remains relevant today.

There are a number of potentially mitigating factors that might temper the relevance of this historical relationship. Three factors that have received particular study of late are: (1) mismeasurement of available workers, (2) mismeasurement of the NAIRU, and (3) changes in the sensitivity of wage inflation to the unemployment rate owing to the rising importance and stability of inflation expectations.

Although the measured unemployment rate is quite low, some would argue that it does not fully capture the population available for work. Relative to the late 1990s, the labor force participation rate (LFP) and the employment-to-population ratio remain low, suggesting that there is some room for the total workforce to expand. On the other hand, the aging of the baby boom makes the return to past peaks in LFP or the employment-to-population ratio less than certain.

The NAIRU is difficult to measure and is affected by a number of demographic and institutional factors. There is a wide range of credible estimates of the current NAIRU—4.7 to 5.2—suggesting that labor markets may not be quite as tight as the consensus estimate would imply.

The sensitivity of wage inflation to the unemployment rate depends in part on the inflation expectations of workers. Despite elevated levels of price inflation of late, inflation expectations remain well-contained, likely tempering the magnitude of cost-of-living based wage increases demanded by workers.

The graph is part of the latest Economic Outlook from Mary C. Daly, vice president FRBSF. The entire report is on the continuation page:

Class Materials for Lecture 16

Brief Outline of Topics Covered in Lecture 16

Chapter 25 Rational Expectations and Implications for Policy

• New Classical Macroeconomics Model
  • Effects of unanticipated and anticipated policy
  • Can an expansionary policy lead to a decline in aggregate output?
  • Policy ineffectiveness and implications for policymakers

• New Keynesian Model 
  • Effects of unanticipated and anticipated policy
  • Implications for policymakers

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

Materials from class:

Video:

Lecture 16 - Chapter 25, pgs. 641-652
Google Video

Additional Reading:

• Gauging Inflation Expectations - WSJ Washington Wire
• Comments on "Understanding the Evolving Inflation Process" FRB Richmond, Lacker
• Update on China: A Monetary Policymaker's Report - FRBSF, Yellen
• Liquidity and monetary policy - FRB: Speech, Kroszner
• U.S. Economic Outlook - Moskow - Federal Reserve Bank of Chicago
• Understanding the evolving inflation process - FRB Speech, Kohn
• Home Foreclosures May Total 1.5 Million in U.S. as Subprime Bust Deepens
• Varian: Observe, Theorize, Measure, and Test
• Does Relabeling the Hours of the Day Save Energy?

Application:

A report on potential problems in the subprime mortgage securities market:

Crisis Looms in Mortgages, by Gretchen Morgenson, NY Times: ...Investment manias are nothing new... But the demise of [the mortgage securities market] has been broadly viewed as troubling, as it involves the nation’s $6.5 trillion mortgage securities market, which is larger even than the United States treasury market.

Class Materials for Lecture 15

Brief Outline of Topics Covered in Lecture 15

Chapter 24 Money and Inflation

• Debt monetization

• The activist/non-activist debate
  
  • Policy lags and other problems in pursuing activist policies

Chapter 25 Rational Expectations and Implications for Policy

• RE and the Lucas critique

Materials from class:

None for today

Video:

Lecture 15 - Chapter 24, pgs. 626-635; Chapter 25, 639-641
Google Video

Additional Reading:

• Milton Friedman: Why Money Matters
• Kenneth Rogoff: Hedge Fund Transparency and Regulation
• Greenspan's Shadow Needs to Shrink
• Bernanke Says Fannie Mae, Freddie Mac Need to Cut Portfolios, Heed Mission
• Greenspan Predicts 'One-Third Probability' of U.S. Recession This Year

Application:

Productivity and Unit Labor Costs: Revised productivity figures were released today (3/6). The revisions were driven by a large upward revision in labor hours. This had two effects. First, with hours revised upward, output per hour - our measure of productivity - declines. Second, with a decline in productivity, unit labor costs increase. Thus, the other side of this is that with higher labor costs, output prices are more likely to be reset upward. This brings about inflation pressure making the Fed more likely to raise rates at renewed signs of inflation, and less likely to cut rates if signs of weakness show up in the data. (To be clear, the revisions to productivity and labor costs won't be news to the Fed - they were widely advertised and anticipated - so this news is already in the Fed's information set and policy response).

Midterm 2 Solution

Midterm 2 and Solution

Class Materials for Lecture 14

Brief Outline of Topics Covered in Lecture 14

Chapter 22 Aggregate Demand and Supply Analysis

• Shifts in the AS curve
  
  • Shifts in the SRAS
  • Shifts in the LRAS and RBC models

Chapter 24 Money and Inflation

• Inflation
  
  • Monetarist view
  • Keynesian view
  • Supply shocks
  • Always a monetary phenomena?

• How does inflationary policy arise?
  
  • Cost push - demand for higher wages
  • Demand pull - shooting at the wrong target

• Budget deficits and inflation

Materials from class:

Video:

Lecture 14 - Chapter 22, pgs. 569-580; Chapter 24, pgs 613-626
Google Video

Additional Reading:

• Forecasting Recessions
• Bernanke: Globalization May Have Increased Inflation
• Expected Inflation
• Explicit Inflation Targeting as a Commitment Device
• Risk Manager: A Nobel laureate says learning can be costly
• Liquidity and Financial Markets - Tim Geithner - FRB New York
• Fed Doesn't Think Sub-prime Mortgages are a Problem - John Berry
• Long-term fiscal challenges and the economy - Bernanke
• The aging workforce - FRB Gov Kohn

Application:

Ben Bernanke on globalization and monetary policy:

Globalization and Monetary Policy, by Ben Bernanke, FRB: My topic this evening is the implications of ongoing global economic integration “globalization” for short--for U.S. monetary policy.

Class Materials for Lecture 13

Brief Outline of Topics Covered in Lecture 13

Chapter 22 Aggregate Demand and Supply Analysis

• Aggregate Demand
  
  • Monetarist view
  • Keynesian view

• Shifts in the AD curve
  
  • Monetary policy (M)
  • Fiscal policy (G,T)
  • Other factors

• Aggregate supply
  
  • Aggregate supply in the short-run
  • Aggregate supply in the long-run

• Equilibrium
  
  • Does the economy self-correct?

Materials from class:

Video:

Lecture 13 - Chapter 22, pgs. 561-568
Google Video

Additional Reading:

• Amy Finkelstein: The Costs and Benefits of Universal Health Insurance
• FRB Dallas - Economic Outlook
• John Taylor: The Iraq Currency Plan Was a Big Success
• Is the Wide, Wide World of Economics Too Wide?

Application:

This post from earlier today noted that there is evidence that the relationship between inflation and measures of real activity such as the unemployment rate has weakened in the last twenty-five years. I want to return to this topic.

Class Materials for Lecture 12

Brief Outline of Topics Covered in Lecture 12

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

• The Fed cannot control both i and M simultaneously

• Poole's Pules
  
  • Unstable IS curve
  • Unstable LM curve

• The IS-LM model in the long-run
  
  • Natural rate of output
  • Monetary and fiscal policy in the short-run and long-run

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

Materials from class:

Video:

Lecture 12 - Chapter 20, pgs. 549-558
Google Video

Additional Reading:

It’s Time to Ask the Next Question, by Mark Thoma, Cato Unbound

Fed's Inflation Analysis Ranks With Zimbabwe's, by Caroline Baum, Bloomberg

Barney Frank: Explicit Inflation Target a "Terrible Mistake"
Bies Says Subprime Mortgage Market is Behaving in a 'Problematic' Way

Application

Consumer Prices Jump 0.2% On Higher Food, Medical Costs, by Jeff Bater, WSJ: Consumer prices and core inflation both rose higher than expected during January, as food costs jumped and medical care posted the biggest increase in 15 years.

The consumer price index rose 0.2%, the Labor Department said Wednesday. The CPI increased 0.4% in December. Core inflation, which is consumer prices excluding food and energy costs, increased by 0.3%, after rising 0.1% during each of the three previous months. Unrounded, the core CPI rose 0.174% in January; it rose 0.256% in December.

Review Questions for Midterm 2

Definitions

Quantity equation
Velocity of money
Equation of exchange
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
Short-run and long-run in AD/AS model

Essay

These are from the first set of review questions and cover the material we didn't get to for the first exam:

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

21. Use the supply and demand model for bank reserves to explain and illustrate the effects of (a) an open market operation to buy bonds, (b) a decrease in the discount rate, and (c) an increase in required reserves.

22. 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 of open-market operations relative to the other tools?

23. 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.

And here are the rest:

1. 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?

2. Is velocity a constant in Keynes liquidity preference theory? When actual data is examined, does velocity appear to be a constant? Why is this important?

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

4. 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?

5. Show the money demand curve graphically. Show how the money demand curve shifts when income increases.

6. 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?

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

8. Explain Friedman's Modern Quantity Theory of the Demand for Money.

9. What is the 45 degree line diagram? What is the expenditure multiplier?

10. What is the slope of the expenditure function? What factors cause the expenditure function to shift?

11. Derive the IS curve. Explain intuitively why it slopes downward.

12. Derive the LM curve. Explain intuitively why it slopes upward.

13. What factors cause the IS curve to shift? In what direction do they shift the IS curve?

14. What factors cause the LM curve to shift? In what direction do they shift the LM curve?

15. Is the equilibrium in the IS-LM model stable? Explain.

16. Show graphically and explain intuitively how an increase in government spending affects income and the interest rate in the IS-LM model.

17. Show graphically and explain intuitively how an increase in the money supply affects income and the interest rate in the IS-LM model.

18. Explain why the LM curve is vertical when money demand is unaffected by changes in the interest rate (as in the classical model).

19. Use the IS-LM model to show that monetary policy becomes more effective relative to fiscal policy as money demand becomes less sensitive to the interest rate. Explain the result intuitively.

20. Explain why investment is less sensitive to interest rate changes in recessions as compared to when the economy is operating closer to full employment. Explain why the IS curve is vertical when investment is completely insensitive to changes in the interest rate.

21. Use the IS-LM model to show that fiscal policy becomes more effective relative to monetary policy as investment becomes less sensitive to the interest rate. Explain the result intuitively. What does this imply about the use of monetary and fiscal policy over the business cycle?

Wednesday:

22. Show that the Fed cannot continuously hit both a money supply target and an interest rate target, i.e. that it must choose one or the other.

23. Explain Poole's rules.

24. Do changes in the money supply and government spending affect output in the long-run? Explain using the IS-LM model.

25. Derive the aggregate demand curve from the IS-LM model and explain intuitively why it slopes downward. What factors cause the AD curve to shift? In what direction do they shift the AD curve?

Class Materials for Lecture 11

Brief Outline of Topics Covered in Lecture 11

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

• Effectiveness of Monetary and Fiscal Policy Graphically and Intuitively
  
  • Responsiveness of money demand to the interest rate
  • Responsiveness of investment to the interest rate

Materials from class:

None for today

Video:

Lecture 11 - Chapter 20, pgs. 546-549
Google Video

Additional Reading:

FRBSF: The Outlook for the Economy
Should Central Bankers "Stick to Their Knitting"?
De Rato Defends IMF Latin America Role; Seeks 'Better Answers'
Federal Reserve Bank of Chicago - U.S. Economic Outlook
Poole Speech - U.S. Saving
Bloomberg - Bernanke, Sparring With Frank, Says Fed May Lift Rate
Washington Wire - Bernanke's Long View on Owning Stocks
John M. Berry - Bernanke Says Nothing New, the Markets Love It
Bloomberg - Poole Says Risky Mortgages 'Coming Home to Roost'

Application:

Central Banks Face Rising Pressure From Politicians, by Simon Kennedy and Matthew Benjamin, Bloomberg: When politicians tried to pressure former European Central Bank President Wim Duisenberg, he used to say: ''I hear, but I do not listen.'' These days, a growing number of central bankers worldwide are hearing a lot -- and some are listening.

The Bank of Japan refrained from raising interest rates last month in the wake of government pressure. The autonomy of banks from Ecuador to India is under attack. French presidential candidates are demanding the ECB meet a goal for growth.

''Political pressure is definitely intensifying,'' says Stephen Roach, chief economist at Morgan Stanley in New York.

Class Materials for Lecture 10

Brief Outline of Topics Covered in Lecture 10

Chapter 20 The IS-LM Model

• The LM Curve
  
  • Derive LM curve from money demand - money supply diagram
  • Shifts in the LM curve
• Equilibrium
  • Stability of equilibrium

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

• Changes in the equilibrium values of output and the interest rate
  
  • Monetary policy in the IS-LM model
  • Fiscal policy in the IS-LM model

Materials from class:

Video:

Lecture 10 - Chapter 20, pgs. 531-535; Chapter 21, pgs. 539-546
Google Video

Additional Reading:

How Paul Volcker became a practical monetarist
The "Global Shortage of Hard Assets"
China's Inflation, Money Supply Growth Moderate, Easing Pressure on Rates
Monetarism as an Oral Tradition?

Application:

Federal Reserve Chairman Ben  Bernanke is testifying before congress today on monetary policy. Here's a summary of Ben Bernanke's testimony so far:

Bernanke Says Inflation Slowing; Not Ready to Relax, by Scott Lanman, Bloomberg: Federal Reserve Chairman Ben S. Bernanke said declining energy and commodity prices are likely to reduce inflation, though it will be a while before the Fed relaxes its guard.

''There are some indications that inflation pressures are beginning to diminish,'' he told the Senate Banking Committee in Washington. ''The monthly data are noisy, however, and it will consequently be some time before we can be confident that underlying inflation is moderating as anticipated.''

Bernanke reiterated the Fed's stance that it's more worried about inflation than a housing-led economic slowdown, making an interest-rate increase more likely than a cut. Policy makers have kept their benchmark rate unchanged at 5.25 percent since ending a two-year run of increases in August and voted unanimously on Jan. 31 to leave it there.

Class Materials for Lecture 9

Brief Outline of Topics Covered in Lecture 9

Chapter 20 The IS-LM Model

• Review of the expenditure function and the 45 degree line diagram
  • Consumption, investment, government spending, and net exports
  • Autonomous expenditures
  • The MPC
  • The expenditure function and equilibrium in the 45 degree line diagram
  • The expenditure multiplier
• The IS curve
  • Investment and the interest rate
  • Net exports and the interest rate
  • Derive the IS curve from 45 degree line diagram

Materials from class:

Video:

Lecture 9 - Chapter 20,  pgs. 513-531
Google Video

Additional Reading:

“Yes, Virginia, Income Inequality is Still Rising”, by Mark Thoma, Cato Unbound

Econolog: New Takes on the New Deal
Hal Varian: Kaizen, That Continuous Improvement Strategy
Kenneth Rogoff: Why Hasn't the Dollar Crashed Yet?
When It Comes to Innovation, Geography Is Destiny, by G. Pascal Zachary, NY Times

Application:

Unless there's a drastic change in the economic outlook, don't get your hopes up for a cut in the Fed's target rate of interest anytime soon:

Fed Officials Still Wary Of Inflation, by Michael S. Derby, WSJ: Inflation pressures have clearly not moderated enough to quell Federal Reserve officials' repeated warnings they may yet have to raise rates again.

Several policy makers said Friday that while they are optimistic inflationary pressures will wane this year, they nonetheless stand ready to cure too-high price pressures with rate increases, if needed. ...

Class Materials for Lecture 8

Brief Outline of Topics Covered in Lecture 8

Chapter 19 Money Demand

• Further Developments in the Keynesian Approach
  • Why Transactions demand depends upon i (Baumol)
  • Tobin's Uncertainty Theory
• Friedman’s Modern Quantity Theory of Money

Materials from class:

Video:

Lecture 8 - Chapter 19,  pgs. 501-510
Google Video

Additional Reading:

Speech by Chairman Ben S. Bernanke on the level and distribution of economic well-being
As Inflation Soars, Zimbabwe Economy Plunges
Come with Me to the FOMC, Remarks by Governor Laurence H. Meyer, Willamette University, Salem, Oregon April 2, 1998
Speeches by Fed Officials Had Less Influence on Treasury Market in 2006
Fewer buyers are checking out 

Application:

Productivity in the fourth quarter was higher than expected easing the pressure on unit labor costs:

Productivity Growth Rebounds, Easing Pressure on Labor Costs, WSJ: U.S. productivity growth rebounded during the fourth quarter of 2006, easing pressure on labor costs and suggesting that the economy still has the potential to generate strong growth without inflationary pressures. ...

Midterm 1 Solution

Midterm 1 and Solution.

Class Materials for Lecture 7

Brief Outline of Topics Covered in Lecture 7

Chapter 19 Money Demand

• Quantity Theory of Money
  • Velocity of Money and Equation of Exchange
  • Quantity Theory
  • Quantity Theory of Money Demand
• The Cambridge Approach
• Is velocity a Constant?
• Keynes’s Liquidity Preference Theory
  • Transactions Motive
  • Precautionary Motive
  • Speculative Motive
  • Putting the Three Motives Together
• Further Developments in the Keynesian Approach

Materials from class:

Video:

Lecture 7 - Chapter 19,  pgs. 493-500
Google Video

Additional Reading:

FOMC statement
Private Money
In Translation
CBO: Economic Volatility
FRB Dallas: Does Foreign Direct Investment Help Emerging Economies?
Will the Euro Replace the Dollar?

Application:

No surprise, the Fed left the target rate at 5.25%. But the accompanying statement is a bit of a departure from the Fed's last few statements issued after FOMC target rate decisions. The statement says:

Review Questions for Midterm 1

These are homework/review questions for the first exam. The list is extensive - it covers all the topics we covered in class (some of which we will cover next week). A thorough understanding of these questions is a good study guide for the exam.

Definitions

Medium of exchange/Double coincidence of wants
Unit of account/Multiplicity of prices
Store of value/Liquidity
Liquidity
FOMC
FAC
Discount window
Discount rate
Member bank
Board of Governors
Monetary base
Borrowed and Non-borrowed reserves
Federal funds rate
Asset
Liability
Demand Deposit
Bank Reserves
Reserve Requirement
Required Reserves
Excess Reserves
Currency
Lender of Last Resort
Money multiplier
Dynamic and defensive open-market operations
Primary, secondary, and seasonal credit

Essay

Chapter 3

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

2. To be useful as a medium of exchange, what properties should money have?

3. Describe the evolution of money from barter to fiat money. How did paper money arise?

4. How is money measured? Why is there more than one definition of the money supply? Are data on the money supply reliable?

Chapter 4

5. How do nominal interest rates, ex-ante real interest rates, and ex-post real interest rates differ? Of the two real rates, which is the most important for understanding economic decisions?

Chapter 12

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

7. How do member banks differ from other banks? How did the difference change in 1980?

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.

Chapter 13

14. Use t-accounts to show that the Fed can control the monetary base better than it can control either currency or reserves. What does this result tell us?

15. Suppose that a bank has $100,000 in excess reserves that it loans out. Assuming that the required reserve ratio is 20%, use t-accounts to illustrate the multiple deposit creation process. Use this to obtain the simple deposit multiplier.

16. 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.

Chapter 14

17. Explain why the multiplier falls when people hold currency or when banks hold excess reserves.

18. 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.

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

Chapter 15

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

21. Use the supply and demand model for bank reserves to explain and illustrate the effects of (a) an open market operation to buy bonds, (b) a decrease in the discount rate, and (c) an increase in required reserves.

22. 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 of open-market operations relative to the other tools?

23. 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.

Class Materials for Lecture 6

Brief Outline of Topics Covered in Lecture 6

Chapter 14 Determinants of the Money Supply

The Money Supply Model and the Money Multiplier

• Deriving the Money Multiplier

Factors That Determine the Money Multiplier

• Changes in the Required Reserve Ratio, r
• Changes in the Currency Ratio, c = C/D
• Changes in the Excess Reserves Ratio, e = ER/D

Additional Factors That Determine the Money Supply

• Changes in the Nonborrowed Monetary Base, MB_n
• Changes in Borrowed Reserves BR, from the Fed

Chapter 15 Tools of Monetary Policy

The Market for Reserves and the Federal Funds Rate

• Supply and Demand in the Market for Reserves
• How Open Market Operations, Discount Lending, and Changes in Reserve Requirements Affect the Federal Funds Rate

Open Market Operations

• Daily Conduct
• Advantages of Open Market Operations

Discount Policy

• Operations of the Discount Window
• Lender of Last Resort
• Advantages and Disadvantages of Discount Policy

Reserve Requirements

• Disadvantages of Reserve Requirements

Materials from class:

Video:

Lecture 6 - Chapter 14,  pgs. 351-367; Chapter 15, pgs. 373-389
Google Video

Additional Reading:

ECB warns on ‘unstable’ financial markets
Bernanke, Trichet Find Cheaper Oil Raises Inflation Risks
Regulatory Relief for Banking Organizations (eliminating open market operations)
A shining city for life sciences (Larry Summers)
How does your brain respond when you think about gambling or taking risks?
Who Was Milton Friedman?

Application:

This Economic Letter from Glenn Rudebusch of the San Francisco Fed discusses monetary policy inertia:

Monetary Policy Inertia and Recent Fed Actions, by Glenn D. Rudebusch, Economic Letter, FRBSF: In the latest episode of monetary tightening in the United States, the Federal Open Market Committee (FOMC), which sets U.S. monetary policy, raised the target level of its key policy interest rate, the federal funds rate, from 1% in June 2004 to 5-1/4% in June 2006. This gradual increase was accomplished via a sequence of 17 consecutive 25-basis-point increases at successive FOMC meetings. This slow, steady two-year adjustment of the policy rate can be given two different interpretations. One of these is that the gradual nature of the policy adjustment reflected a slow internal response by the FOMC, which knew where it was going and how fast it wanted to get there and simply took its time in raising the funds rate to the desired level. The other interpretation is that the final level and the speed of adjustment to that level were not known for sure in advance, so the gradual nature of the policy rate adjustment importantly reflected economic developments and data released during the tightening. Based on the research summarized in Rudebusch (2006), this Economic Letter describes these two interpretations and assesses their relative importance in accounting for recent monetary policy actions.

Class Materials for Lecture 5

Brief Outline of Topics Covered in Lecture 5

Chapter 13 Multiple Deposit Creation and the Money Supply Process

Control of the Monetary Base

• Open Market Operations with Bank
• Open Market Operations with an Individual and shifts between Currency and Deposits
• Discount Loans
• Overview of the Fed’s Ability to Control the Monetary
   Base

Multiple Deposit Creation: A Simple Model

• Deposit Creation
• Deriving the Formula for Multiple Deposit Creation
• Critique of the Simple Model

Materials from class:

Chalk only today.

Video:

Lecture 5 - Chapter 13,  pgs. 340-347
Google Video

Additional Reading:

US productivity growth lowest for decade, by Chris Giles, Financial Times
The great unbundling, Does economics need a new theory of offshoring?
Big Bank Stops Effort to Change Law Limiting Growth
The Great Moderation
Fed Will Hold Rate, Stay Focused on Inflation, by John M. Berry, Bloomberg:

Application:

Kenneth Rogoff looks at the risks from unexpected changes in macroeconomic volatility:

The $200 Trillion Question, by Kenneth Rogoff, Project Syndicate: Perhaps the most remarkable trend in global macroeconomics over the past two decades has been the stunning drop in the volatility of output growth. In the United States, for example, quarterly output volatility has fallen by more than half since the mid-1980’s. Obviously, moderation in output movements did not occur everywhere simultaneously. ... But by now, the decline has become nearly universal, with huge implications for global asset markets.

Class Materials for Lecture 4

Brief Outline of Topics Covered in Lecture 4

Chapter 12 Structure of Central Banks and the Federal Reserve System

Informal Structure of the Federal Reserve System

• How Power Has Been Centralized Over Time

How Independent is the Fed?

Should The Fed Be Independent?

• The Case for Independence
• The Case Against Independence

Chapter 13 Multiple Deposit Creation and the Money Supply Process

Four Players in the Money Supply Process

The Fed’s Balance Sheet

• Liabilities
• Assets

Control of the Monetary Base

• Open Market Operations with Bank
• Open Market Operations with an Individual and shifts between Currency and Deposits

Materials from class:

Central Bank Independence and Inflation

From "Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence," by Alberto Alesina and Lawrence H. Summers, Journal of Money, Credit and Banking, Vol. 25, No. 2. (May, 1993), pp. 151-162  (the link will work on UO net, but I don't expect you to read the paper as it is a bit technical):

This has changed with the adoption of inflation targeting by central banks. Note also that Adam Posen casts doubt on whether causality runs from central bank independence to improved macroeconomic performance in Central Bank Independence and Disinflationary Credibility: A Missing Link?, NY Fed Staff Report, May 1995.

Video:

Lecture 4 - Chapter 12,  pgs. 321-330; Chapter 13, pgs. 333-340
Google Video

Additional Reading:

Fed Independence
Bernanke: Entitlement Spending Threatens Future Economy
Bernanke Senate Testimony - Long-term fiscal challenges facing the United States
Tim Haab: Speaking with the Enemy
Email interview with Milton Friedman
The value of scalping - The Boston Globe

Application:

Federal Reserve Governor and the author of your textbook, Frederic Mishkin on how the Fed should respond to asset price bubbles, in his case, bubbles in the housing market:

The Role of House Prices in Formulating Monetary Policy, by Frederic S. Mishkin, Federal Reserve Board: Over the past ten years, we have seen extraordinary run-ups in house prices. From 1996 to the present, nominal house prices in the United States have doubled, rising at a 7-1/4 percent annual rate.1 Over the past five years, the rise even accelerated to an annual average increase of 8-3/4 percent. This phenomenon has not been restricted to the United States but has occurred around the world. For example, Australia, Denmark, France, Ireland, New Zealand, Spain, Sweden, and the United Kingdom have had even higher rates of house price appreciation in recent years.

Class Materials for Lecture 3

Brief Outline of Topics Covered in Lecture 3

Chapter 12 Structure of Central Banks and the Federal Reserve System

Origins of the Federal Reserve System

• Distribute power to geographic regions, the public sector, the private sector, the business sector, and the financial sector

Formal Structure of the Federal Reserve System

• Federal Reserve Banks
• Member Banks
• Board of Governors of the Federal Reserve System
• Federal Open Market Committee (FOMC)
• The Federal Advisory Council (FAC)

Informal Structure of the Federal Reserve System

• How Power Has Been Centralized Over Time

Materials from class:

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

Video:

Lecture 3 - Chapter 12,  pgs. 311-321
Google Video

Additional Reading:

Dual Banking in the U.S.
A brief History of the U.S. Payments Mechanism
The Evolution of Central Banking in the U.S.

Application:

Federal Reserve Chair Ben Bernanke testifies about monetary policy next month and the questioning may be a bit different than in recent years due to the new power structure in Congress:

Fed Chairman May Face Heat At Hearings, by Greg Ip, Wall Street Journal: When Federal Reserve Chairman Ben Bernanke testifies on monetary policy next month, he is likely to get far more scrutiny than usual.

By law, the Fed chairman must testify twice a year to Congress: in February and July. Ordinarily, each installment lasts two days, one before the Senate Banking Committee, the other before the House Financial Services Committee. There are no other witnesses.

Class Materials for Lecture 2

Brief Outline of Topics Covered in Lecture 2

Chapter 3 What is Money? [pages 48-55]

Evolution of the Payments System

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

Measuring Money

• The Federal Reserve’s Monetary Aggregates

How Reliable Are the Money Data?

Chapter 5 The Behavior of Interest Rates [pages 79-82]

The Distinction between Real and Nominal Interest Rates

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

Materials from class:

Video:

Lecture 2 - Chapter 3, pgs. 53-61; Chapter 4, pgs. 87-90
Google Video

Additional Reading:

The Stone Money of Yap
Technology and Class Attendance (a worry of mine...)
Benjamin Franklin and the Birth of a Paper Money Economy
Fed Watch by Tim Duy: Like a Broken Record

Application:

This is a summary of a speech by Federal Reserve governor Donald Kohn (text of speech):

Fed's Kohn Says 'Too Early to Relax' on Inflation, by Craig Torres and Steve Matthews, Bloomberg: Federal Reserve Vice Chairman Donald Kohn said it's ''still too early'' for the central bank to relax its guard on inflation as the economy is set for a moderate expansion in 2007.

''It is still too early to relax our concerns about whether the run-up in price pressures in the spring and summer of last year is truly unwinding,'' Kohn said in a speech to the Rotary Club of Atlanta. It's also premature to judge that inflation is slowing ''rapidly enough to forestall a pickup in inflation expectations,'' he said.

Class Materials for Lecture 1

Brief Outline of Topics Covered in Lecture 1

Chapter 1 Why Study Money, Banking, and Financial Markets? [pages 8-13]

Why Study Money and Monetary Policy?

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

Chapter 3 What is Money? [pages 23-48]

Meaning of Money
Functions of Money

Medium of Exchange
Unit of Account
Store of Value

Materials from class:

Video:

Lecture 1 [Media Player] - Chapter 1, pgs. 8-13; Chapter 3, pgs. 49-52
Lecture 1 [Google Video]