Transcript Document

ECN202: Macroeconomics
1970s: Experiments with Money
The Domestic Dimension
"neither a state nor a bank ever has had unrestricted power of
issuing paper money, without abusing that power; in all States,
therefore, the issue of paper money ought to be under some check
and control; and none seems so proper as that of subjecting the
issuers of paper money to the obligation of paying their notes, either
in gold coin or bullion."
1970s Domestic
This would be a decade in which liberals would experiment
with Keynesian monetary policies, only to have the
experiment terminated in the late 1970s when Paul Volcker,
Fed chair, embraced Monetarism. He did this because the
experiment led to the only period of sustained peacetime
inflation in US history. At the center of this unit is interest
rates, so you will need to understand the equation that
breaks down interest rates into its separate components.
These interest rates are “managed” by the Fed, so we’ll also
look at how the Federal Reserve manages those interest
rates and how changes in those rates affect the economy. In
the next few slides you will see headlines that pertain to the
material in this unit – headlines about interest rates and
monetary policy.
In the news
“Interest rates on Italian bods pushed to new levels”
“Italy Rates Remain Near Two-Year Record Low”
“The world isn’t flat, but its yield curve may be”
“States and cities start rebelling on bond ratings”
“International capital flows alter US interest rates”
“Poland Finds It’s Not Immune to Euro Crisis”
“China Cuts Lending Rate as Economic Growth
Slows”
8. “As Low Rates Depress Savers, Governments Reap
Benefits”
9. “Low rates may do little to entice nervous consumers”
1.
2.
3.
4.
5.
6.
7.
In the news
1.
2.
3.
4.
5.
6.
7.
“Fed's Move Toward 'Monetarists” 1972
“Humility at the Fed; Inflation Brakes Don't Work So
Well” 1973
“Fed May Be Sharply Expanding Credit Supply,
Analysts Assert” 1973
“Fed Tries Way Of Monetarists” 1979
“Economists Criticize Volcker; Galbraith Issues
Warning” 1979
“Miller Suggests Fed Moved Too Quickly;
Uncertainty on Third Step” 1979
“CAN VOLCKER STAND UP TO INFLATION?”
1979
In the news
1.
2.
3.
4.
5.
6.
7.
8.
9.
“Pain spreads as credit vice grows tighter”
“The Fed’s monetary policy response to the current
crisis”
“How the Fed can fix the world”
“Paying the price for the Fed’s success”
“The Fed plans to inject another $1 trillion to aid the
economy”
“Fed Chief’s reassurance fails to halt stock market
plunge”
“Fed ties new aid to jobs recovery”
“Dear Ben: It’s time for your Volcker moment”
“Rising inflation limits Fed as growth lags”
A great invention?
1. "Money connected human in a more extensive and
efficient way than any other known medium. It
created more social ties, but in making them faster
and more transitory, it weakened the traditional ties
based on kinship and political power."
2. "[t]he use of counting and numbers, of calculating
and figuring, propelled a tendency toward
rationalization in human thought that shows in no
human culture without the use of money. Money did
not make people smarter; it made them think in new
ways, in numbers and their equivalencies. It made
thinking far less personalized and much more
abstract."
A few things to know about interest rates
1.) there are many interest rates that tend to
move together.
A few important interest rates
Discount rate: rate that the FED charges banks for
overnight borrowing
Federal funds rate: rate banks charge other banks for
overnight borrowing – Fed sets target for this rate
Treasury-bill rate: the rate on short-term (<1 year) on
government securities
Mortgage rate: the rate on home loans, car loans
Robert Hall, Why does the economy fall to pieces after a financial crisis
Can you see when the financial
crisis hit from this graph?
When corporate Baa bonds
surged and Treasuries sank = sign
investors moved to safe
investments
Rate on banks overnight
borrowing targeted by Fed
Rate on US government debt
with 6-month maturity
Look at these graphs on next few
slides and see if you can see the
similarities – and differences
Rate on US government debt
with 6-month maturity
Rate on US government debt
with 10-year maturity
What about those differences?
Are investors worried about the
US’s ability to repay its debt?
Rate on US government debt
with 10-year maturity
Rate on 30-year mortgages – this
impact housing demand
You can see that the 1970s was a
problem
Here is my 18.5% mortgage
Use a mortgage calculator to see
what my monthly payment
would be on a $100,000, 30-year
mortgage, and then see what it
would be if the rate were 5%.
monthly payment would be on a $100,000, 30-year
mortgage,
18% = $1,548
5% =.$536
What will this reduction in rates do to demand for
homes?
A few things to know about interest rates
2.) there are many components of risk in each
interest rate.
On the next slide is an equation that specifies the actual
interest rate as dependent on a number of risk components
plus the riskless cost of money that the Fed tries to ‘manage.”
Later you will see this as the equilibrium interest rate in the
money market. You could think of this as the federal funds
rate. The actual rate = this Plus premiums for the risk.
Decomposition of interest rates
r = rr + rd + rm+ ri + rl
where
r = nominal rate (actual rate you pay)
rr = real risk-free rate of interest (Ms - Md)
rd = default risk – you will not bay back
rm = maturity risk – longer time = more things go wrong
ri = inflation effect – more inflation = less return
rl = liquidity effect – ability to turn it into cash
Default Risk
Interest Rates
Corporate debt is riskier = higher
interest rate
16
14
Corporate Aaa
12
10
US 10-yr Treasury
8
6
4
2
0
1950
Municipal
1960
1970
Municipal rate – lower because of
tax benefits
1980
1990
2000
2010
International examples of default risk
1. Argentina Crisis of 1997-1998
2. Asian Crisis (Hong Kong) of 1997
3. Subprime Crisis of 2008
4. Greece Crisis of 2009-2010
1. Argentina Crisis of 1997-98
Argentina Interest Rates
2. Hong Kong Crisis of 1997
3. Subprime Crisis of 2008
The default premium on corporate bonds increases in
recession as investors worry about corporation’s
ability to pay bills
3. Subprime Crisis of 2008
Corporate Aaa - Treasury 10-year
2.50
2.00
Another view of same phenomenon – the gap
between the two rates increases in uncertain/bad
times
1.50
1.00
0.50
0.00
1990
1995
2000
2005
2010
4. Greece Crisis of 2009-2010
Investors get very worried about Greece
Maturity Risk
US Treasury Interest Rates:
3-month & 10-year
14.00
12.00
3-month is less risky than 10year
10.00
8.00
6.00
4.00
10-yr
2.00
0.00
1950
1960
1970
1980
1990
2000
3-mth
2010
Maturity Risk: Another view
Yield Curve for US Treasuries: 2009
5.00
4.50
4.00
3.50
Another view on maturity risk = longer the maturity
the higher the rate. This changes over time and in the
aftermath of the financial crisis the Fed tried to
reduce the slope of the curve. Any ideas on how it
could do that?
3.00
2.50
2.00
1.50
1.00
.50
.00
3-M
6-M
3-yr
10-yr
30-yr
Inflation Risk
Inflation and Interest Rates
16
You can see that interest rates are
closely correlated with inflation rates.
14
What happened in the late 1970s –
and early 1980s?
12
10
Inflation
3-yr Treasury
8
6
4
2
0
1950
-2
-4
1960
1970
1980
1990
2000
2010
Real and Nominal Rates
You saw this before – the relationship between real and nominal interest rates
rn = rr + ie
or
rr = rn - ie
where
rr = real rate
rn = nominal rate
ie = expected inflation rate
Real Interest Rates
10-Yr US Treasury
10
8
Now look at those late 1970s and
early 1980s. Who got “burned” in the
late 1970s and who got burned in
the early 1980s?
6
4
2
0
1950
-2
-4
-6
1960
1970
1980
1990
2000
2010
Lenders got burned in the late 1970s,
and borrowers got burned in the
early 1980s. This was when Latin
America’s debt crisis happened when
they could not repay their debt.
A few things to know about interest rates
(the price of money)
3.) interest rates are prices
a. Keynesian theory of money demand
b. Fed and the money supply process
And if they are prices, behind them is a S&D graph, so
all we need to do is understand who / what is behind
those curves
Interest rates are prices
r*
= interest rates
Ms
Ms
interest rate
ms* = money supply (M1)
Md
0
0
money
Keynesian theory of money demand
Transactions Demand
Higher Income  More Transactions  More
Money Demand
Precautionary & Speculative Demand
Higher Interest Rate  Higher Opportunity Cost
of Money  Lower Money Demand
Money demand: the graph
Speculative demand
@ initial interest rate (r*)
you hold some of your
wealth as bonds and
some as money (m* )
As interest rate falls to r**
the opportunity cost of
holding money declines
so you hold more money
(m**) [also as rates fall you
might expect rates to rise
and you would lose money
holding bonds]
interest rate
r*
*
r**
*
Md
0
m*
0
m**
money
Money demand: the graph
Transactions demand
Income rises = transactions rise
demand rises @ (r*) you will
increase your holdings of so
you hold more money (m* ) new Md curve
interest rate
*
r*
**
Md
0
0
m*
m**
money
Md
Money supply
Interest rate
When we talk about the money supply
we are talking about the amount of cash
(coins & currency) + the value of
checking accounts (demand deposits).
The idea behind this measure is that this
is the amount available for transactions.
Given this definition, there are three
major players that the money supply that
you can see in the following diagram
Money
1.Federal Reserve – control the S of
cash (high-powered-money)
2. Commercial Banks – control the amount of checking accounts
issued
3. Businesses & Households – they are the users of the money
and decide what form of money they want to hold.
Money Supply Process
Fed
$s
Banks
Reserves
$s
$s
Individuals & Businesses (Ms)
Checking Account $s + Cash $s
Players
Money supply
1. Federal Reserve (FED)
– This institution controls the supply of high-powered money
(cash)
– The most powerful unelected official responsible for US
monetary policy is Fed Chair – Ben Bernanke
– The banks structure is outlined in following diagram. The
real power rests in the hands of the Federal Open Market
Committee (FOMC). They ultimately decide on what to do
with the money supply/interest rates. Actually you will hear
about their interest rate targets,
but they achieve those targets
by altering the money supply.
2.
Federal Reserve structure
Players
Money supply
2. Commercial Banks
– These institutions are financial intermediaries – they take in
our deposits and pay a certain interest rate and then invest
the money at higher interest rates. They can loan money to
the US government when they buy Treasuries (US bonds)
and they can lend to businesses and households by creating
checking accounts balances. The key feature of the banking
system is it is a fractional reserve system, which means that
banks can loan out more money than it has in its vaults. This
makes banks vulnerable to runs banks since there is not
enough cash in the banks if all of the
customers with deposits want their
money back. Because banks want
to make as much profit as possible
they will loan out as much money as
they can, which is why the Fed
regulates how much the banks must
hold as cash.
What happens in a fractional reserve system
Think of goldsmiths in the Robin Hood days who robbed those
with gold traveling through Sherwood Forest. Eventually someone
figured out how to beat the system – deposit the gold in a safe
place (goldsmiths) who gave paper receipts proving ownership of
the gold for a small fee. Now Robin Hood would only get pieces of
paper. The goldsmiths soon realized they would end the day with
gold in the vaults, so they issued more paper specifying
ownership of gold. This worked as long as everyone with the
paper did not show up and demand gold since there would not be
enough. The good news was a small amount of gold could
“create” a larger money supply needed to support more
transactions. The bad news was it was risky and prone to runs on
the goldsmiths. To understand banks, just replace gold with highpowered-money (currency) supplied by the Fed and the paper
receipts with checking accounts and you have the modern
fractional reserve system.
Banks & fractional reserve system
Regulations of commercial banks
Because of the central role money plays in our economy –
without it the system would grind to a halt – banks are highly
regulated. The big push to regulate banks came in the Great
Depression was made worse by the closing of banks that had
made risky investments with depositors funds. To stabilize the
banking system, the following regulations were put in place.
1.Deposit insurance: deposits were guaranteed by the federal
government, which eliminated bank runs
2.Bank examinations: the books of banks were regularly
reviewed
3.Limitations on assets: banks were restricted in terms of what
they could do with the deposits (after the Great Depression
they could not buy corporate stock)
4.Required reserves: banks must hold a percent of their
outstanding deposits as cash – the required reserve rate
Players
3. Individuals and businesses
Money supply
– Businesses and households are the ones that hold the
money and what matters is the form in which they hold it.
Because of the fractional reserve system, if you put $100 in
cash in a commercial bank the bank can loan out some
multiple of that amount. If the required reserve rate is 10%,
then that $100 would represent 10% of $1000, so the banks
could loan out money until the total of checking accounts
drawn on the bank totaled $1,000. In this case the $100 of
cash generated $1,000 in the money supply. If you chose to
hold the $100 as cash, then the money supply
would be $100. So, when you decide to hold
more of your money as cash and less as
checking accounts, the money supply
decreases.
It’s a Wonderful Life
Here is what can happen in a
fractional reserve system. When
all of the depositors come to
get their cash the banks do not
have the cash so they simply
close their doors. This is why
Roosevelt established the
Federal Deposit Insurance
Corporation(FDIC) to convince
depositors they could
always get their money. The banks’ investments were also regulated to
reduce the chance of bank bankruptcies. One of the problems with the
financial crisis that led to the Great Recession is the Fed eliminated
restrictions on investments banks could make and they increased risky
investments for > return. Banks can also decide to hold excess cash –
above what they are required – and this will affect the money supply.
What affects the Money Supply?
The factors affecting the money supply fall into
two categories depending on the Fed’s
control.
1.Uncontrolled influences
2.Controlled influences
Now we will look at what would be included in these two
Uncontrolled influences on Money Supply
1. Banks holding of excess reserves (banks hold
excess reserves (extra cash) which is not counted
in Ms and there is less to lend so deposit accounts
go down so Ms decreases.
2. Public’s holding of cash ($1m in hand of public
= +$1m to money supply, but a decline in bank
reserves of $1 means a loss in deposits of a
multiple of the $1. With a required reserve rate (rrr)
of 20%, the multiple = 5 [ = 1/rrr] and the money
supply would fall by $5m for every $1m held as
cash.
Controlled influences on Money Supply
1. OMO: If Fed buys $1m of Treasuries from
banks then bank reserves rise by $1m and
they can loan out a multiple of that $1m.
2. Required reserve rate: If the Fed lowers the
required reserve rate then the bank can lend
out more which means an increase in Ms.
3. Discount rate: If the Fed raises the discount
rate then it is discouraging banks from
lending money, which reduces the Ms.
Fed policies to increase Money Supply
If the Fed would like to increase the money
supply then it would
1. OMO: it would buy Treasuries and pay for
them with new $s that would expand the Ms.
2. Required reserve rate: the Fed would lower
the rrr so banks could lend out more for any
amount of reserves.
3. Discount rate: fed could lower the discount
rate that encourages banks to borrow $s
from the Fed to lend out and increase Ms.
Money Market
If we put the Md and Ms
together we get the money
market where the price = rr
from the interest rate
equation – the riskless rate
of interest. Changes in the
interest rate happen with
changes in either the S or
D – and now we will look at
some sample questions.
_______ Market
Interest rate
$40
P
$30
$20
$10
$0
-
8,000
16,000
24,000
Qmoney
Questions
What would be the impact on interest rates of the
following, and how would you show it with the Ms-Md
diagram?
a. An economic expansion
b. The Fed’s decision to raise the discount rate
c. The Fed’s Open Market purchase of securities
d. People decision to convert their checking accounts
into cash
e. The economy falls into recession and the Fed buys
securities (OMO purchases)
Get that piece of paper out and draw the appropriate diagrams
Questions
a. How do you show
the impact on the
money market of an
economic expansion?
_______ Market
Interest rate
$40
P
$30
$20
$10
$0
-
8,000
16,000
24,000
Qmoney
Questions
b. How do you show the
impact on the money
market of the Fed’s
decision to raise the
discount rate?
_______ Market
$40
P
$30
$20
$10
$0
-
8,000
16,000
24,000
Q
Questions
c. How do you show the
impact on the money
market of the Fed’s
Open Market purchase
of securities?
_______ Market
Interest rate
$40
P
$30
$20
$10
$0
-
8,000
16,000
Money
24,000
Q
Questions
d. How do you show
the impact on the
money market of
people decision to
convert their checking
accounts into cash?
_______ Market
$40
P
$30
$20
$10
$0
-
8,000
16,000
24,000
Q
Questions
e. How do you show
the impact on the
money market if the
economy falls into
recession and the Fed
buys securities (OMO
purchases)?
_______ Market
$40
P
$30
$20
$10
$0
-
8,000
16,000
24,000
Q
Questions
What would be the impact on interest rates of the
following, and how would you show it with the Ms-Md
diagram?
a. An economic expansion - this increases demand for
money = right shift in Md = interest rate & Ms
b. The Fed’s decision to raise the discount rate – this
decreases supply of money = left shift in Ms =
interest rate & Ms
c. The Fed’s Open Market purchase of securities – this
increases supply of money = right shift in Ms =
interest rate & Ms
Questions
What would be the impact on interest rates of the
following, and how would you show it with the Ms-Md
diagram?
d. People decision to convert their checking accounts
into cash – this decreases supply of money = left shift in
Ms = interest rate & Ms
e. The economy falls into recession and the Fed buys
securities (OMO purchases) – this is a double shift decreases demand for money (recession) = left shift in
Md & increases supply of money (Fed) = right shift in
Ms. Combined effect is interest rate & can’t predict
DMs
Questions
8f. What is Fed doing in 1991 – and why?
(rr)
Get that piece of paper out and draw the S&D
graphs of the money market
Questions
The fed was driving
down interest rates,
which it did by
increasing the money
supply. It probably
bought Treasuries
using OMO to increase
the Ms.
_______ Market
$40
P
$30
$20
$10
$0
-
8,000
16,000
24,000
Q
Monetary Policy
What can monetary authorities do
to manage the economy?
Question
Here are two time-series graphs – one of the discount
rate in the US and one of the equivalent (bank discount
rate) in Japan. Please look at the graphs and do a little
reverse engineering to determine what was going on in
the two economies during this 20+ year period – and
what the monetary authorities in the two countries were
doing to “manage” the economy?
Why the difference in the
1990s and why the drop
after 2001?
What is happening here?
The short answer is you can see Japan’s “lost decade”
in the graphs. Japan’s central bank had raised the
interest rate in the early 1990s to stop a speculative
boom, and once the bubble burst it lowered interest
rates dramatically and had to keep them near zero trying
to stimulate the economy. In the US the economy fell
into a recession in the early 1990s so the Fed also
lowered rates, but then began to raise them as the
economy heated up in the Clinton years. In the US after
9/11 and the stock market bust the Fed flooded the
economy with cash and kept them low. This fueled the
housing boom in the US that eventually led to the
financial crisis and the Great Recession.
Monetary Policy and the Economy
Now that we see how the money market works, you
should see what comes next. In the 1970s Nixon “set the
Fed free” so the US could print money, and when the
two recessions induced by OPEC price increases
happened, the Fed responded as Keynes would have
suggested. We will now look at the Keynesian theory of
monetary policy and its influence on the economy. We’ll
also look at The Wizard of Oz in a way that you never
did – as an allegory about monetary policy. First,
however, we recap the Classical “Quantity Theory of
Money.”
Classical “vision” of monetary policy:
Quantity theory of money
MP
You have to love the simplicity – if you print more money people will try to spend
it and because we are at full employment this will result in asn increase in prices.
Keynesian “vision” of monetary & fiscal
policy
Monetary Policy
 M   rr   I   Y
Keynes’ view was a little more involved. An increase in the money
supply (M) would push the interest rate (rr) down and this would
stimulate investment(I) spending and this increase in Investment
spending would have a multiplier effect on GDP (Y).
Now let’s look at what this does to fiscal policy
Keynesian “vision” of monetary & fiscal
policy
Fiscal Policy
GY
MdrrIY
(crowding out effect)
Keynes’ view of fiscal policy changes a bit. Now as the economy expands
(Y) as a result of the increase in government spending (G) there is a
secondary effect. The increase in income increases money demand that
increases the interest rate ( r ) and this reduces Investment spending (I)
that reduces overall national output (Y). This secondary effect is
crowding out and it reduces the full multiplier efect.
Keynesian Monetary Policy
Transmission Mechanism
Now let’s look at that transmission process
0 Recognition and
Discussion lags
1
Sensitivity on Md to
interest rate
2
Sensitivity of spending
to interest rates
3 Spending’s impact on
price & output
Question
What happens if it is discovered that consumption of
automobiles is more sensitive to changes in the interest
rate than previously thought, what impact will this have
on the relative effectiveness of monetary and fiscal
policy?
Try to work your way through the logical chain of events in the
diagram in the following slide. Find the link between interest rate
and Investment in the diagram and then see how a change in
money supply (M) can have an impact on GDP (Y)
Answer
Monetary: Keynesian version
 M  rr  I  AD Y
Fiscal: Keynesian
G  AD  Y1  Md 
r  I  AD  Y2
Here are the two places the link between the interest aret and
investment show up. Now what happens to the links?
Answer
Monetary: Keynesian version
 M  rr  I  AD Y
Bigger = more effective
Fiscal: Keynesian
G  AD  Y1  Md 
r  I  AD  Y2
Bigger = less effective
The first effect dominates so it is more effective
The Fed’s dilemma
In the next side you see the Fed’s dilemma – by altering
the supply of high-powered money it can control either
the price (interest rate) or quantity (Ms). It has to decide
what to control, and that is where the ideological divide
happens.
•Keynesian/ liberals – believe the interest rate is the key
variable to control
•Classical/ conservatives – believe it is important to
control the money supply
So, when the economy is “hit” by the OPEC oil price shock and falls into
a recession, what will the liberals propose – and what would the
conservatives propose?
Fed’s dilemma: respond to
Control interest rate
Md
Control money supply
Increase Ms
Decrease Ms
Ms
Ms
interest rate
interest rate
Md
Md
0
0
0
0
money
Lose control of M
money
Lose control of r
The 1970s
Now let’s look at what happened in the 1970s. OPEC
raised prices and this increased Md and this put
pressure on interest rates to rise. This would have
pushed investment and consumption spending lower
and caused a recession. To avoid this the Fed increased
the money supply and this pushed won interest rates but
also increased inflation which pushed interest rates up.
The fed pumper more money in and for the decade this
pattern continued as you can see in the following
diagram
Story of the 1970s
 P  Md
 Ms  P  Md   r
Fed responds again
 Ms  P  Md
Fed responds to  r by Ms
Interest
rate
Q Money
The “Shift”
The end result of the process was the US experienced
persistent and increasing inflation – the only time in
peacetime in the country’s history. What happened was that
Carter eventually responded with the appointment of the
conservative Paul Volker as Fed Chair who changed
strategies abruptly. He adopted Monetarism, an idea pushed
by conservatives who believed in the need to shift focus to
the money supply. Inflation was the result of too much
money, so now it was time to control the money supply. We
can see what happened in the following diagram.
A shift to Monetarism
The Fed under Volcker
reduced the money supply
_______ Market
Ms
$40
This increased the interest
rate, which would be hard o
claim as a target
P
$30
$20
The Fed ignored interest
rates and announced M
targets that seemed better
politically
$10
Md
$0
-
8,000
16,000
24,000
Q
The results
The Fed’s policies sent the US into its deepest post WW
II recession and soon after the recession the
monetarism policy was abandoned. It created much
human misery, but it did break the inflationary spiral and
set the stage for the second part of the ideological
revolution – the arrival of Ronald Reagan with his
supply-side policies.
And now let’s revisit those early questions
Those questions
As we go through the analysis keep the following two
question in mind.
1. Please explain. "the memory of the Great Depression
meant that the US was highly likely to suffer an
inflationary episode like the 1970s in the post-World war
II period-maybe not as long, and maybe not exactly
when it occurred, but nevertheless a similar episode.”
The reasoning behind the quote is that Keynes had provided the
basis for using monetary policy to stimulate the economy, and
eventually the Fed would use it. Because Keynes was writing in
the 1930s when inflation was not a problem, Keynesians ignored it
and the result was Fed policies that would produce the policies of
the 1970s that created persistent and increasing inflation
Those questions
As we go through the analysis keep the following two
question in mind.
2. "Long after the Pope is gone, you'll remember
this?" What is the change in policy that is being referred
to here, who was responsible for the change, and why
was the policy change quickly called off?
This was a simple one – it was the shift to monetarism that
created those double-digit interest rates (my 18.% mortgage) and
this was truly a shock to the system that would have a bigger
impact that the Pope’s visit.
And one final question on the story the Wizard of Oz.
The Wizard of Oz as
Political Allegory
What is the “economic” story behind The Wizard of Oz – and who
do the characters represent? Who is William Jennings Bryan in
the story – and in real life - and what was his Cross of Gold
speech and how was it related to the story?