Transcript Document

5
Monetary Theory and Policy
John Maynard Keynes, 1883-1946
 Great British Economist
 Father of Keynesian Theory
 Author & Cambridge Professor
 England’s Treasury Secretary
 Had a Seat in House of Lords
 Strong following at Harvard
(especially after Great
Depression, to which
Keynesian theory
was a response.)
 An imposing figure (6’6”) and
a prominent gay figure of his day
 Successful investor (built $.5M into
to $13.2M in 18 years.
Milton Friedman (1912 - 2006 )
 At first a disciple of Keynes. Later rejected Keynes and
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became father of Monetarism
A Nobel Prize winner; likely the most influential
American economist of the 20th century
Known for his laissez-faire or libertarian philosophy;
promoted economic freedom around the world
His principles influenced a number of countries,
including, China, HK, Chile, Iceland, and Estonia
(which went from impoverished communism state to
the Baltic Tiger); and the U.S. (Reagan was a disciple).
He and his wife Rose educated the public about
economic freedom through successful books and a TV
show entitled “Freedom to Choose.”
Awarded Presidential Medal of Freedom by President
Reagan, who was a follower
Supported freedom in many areas: stood for
legalization of drugs & prostitution, school vouchers,
and elimination of the military draft in the U.S.
Helped create tax withholding system in 1942 and the
EITC (both of which he later regretted)
 Believed the Great Depression
was caused by Fed’s refusal to
expand money supply
 Here’s some classic Friedman
http://www.youtube.com/watch?v=R5GppiO3a8&feature=related
Famous Friedman Quotes
 "There's no such thing as a free lunch."
 “I am in favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it's possible."
 "A major source of objection to a free economy is precisely that it [...] gives people what they want instead of what a
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particular group thinks they ought to want. Underlying most arguments against the free market is a lack of belief in
freedom itself."
"The business of business is business“
“I am a libertarian with a small ‘l’ and a Republican with a capital “R”, but only on the grounds of expediency, not on
principle
"Inflation is the one form of taxation that can be imposed without legislation."
"The government solution to a problem is usually as bad as the problem."
"We have a system that increasingly taxes work and subsidizes non-work."
"With respect to teachers' salaries[....] Poor teachers are grossly overpaid and good teachers grossly underpaid.
Salary schedules tend to be uniform and determined far more by seniority."
"If an exchange between two parties is voluntary, it will not take place unless both believe they will benefit from it.
Most economic fallacies derive from the neglect of this simple insight, from the tendency to assume that there is a
fixed pie, that one party can only gain at the expense of another"
“The problem with socialism is that
"Hell hath no fury like a bureaucrat scorned."
eventually you run out of other
"The only social responsibility of business is to increase its profits"
people's money.” Margaret Thatcher
Friedman’s categories of spending money is classic:
Friedman’s Rule
Spend Your $
Spend Other’s $
On Yourself
1. Very Accountable
3. Not Very Accountable (e.g.
company expense report)
On Others
2. Quite Accountable (charity)
4. Extreme lack of accountability
(e.g. government)
Monetarist vs. Keynesian Theories
Suppose the economy is headed downhill:
Monetarist
 Focus is on controlling the money
supply (thus its name) and
inflation.
 Other economic goals, such as
growth and employment will sort
themselves out
 Over time, stable growth reduces
borrowing and lowers interest
rates by default
 Key goal is low inflation, and
the other problems will resolve
themselves over time
 Claims Keynesian approach is a
S/T fix, a kneejerk reaction
 Criticism: Only works over L/T,
can be accused of doing nothing
in the S/T
Keynesian
 Need to take immediate action to
lower interest rates and stimulate
growth (e.g. stimulus)
 Key goals are growth and
employment
 Criticism: Might ignite inflation,
but Keynesians say it’s worth it
Volcker and Greenspan were
monetarists; Bernanke was a
modified monetarist. Yellen is
supposedly an unabashed
Keynesian.
Two Great Leaders Apply Monetarist Policies
In 1979, Mrs Thatcher was elected Prime Minister of the UK.
At the time, the UK was experiencing double digit inflation,
trades unions were powerful and there was a feeling British
industry had become uncompetitive in the post war period.
Mrs Thatcher introduced revolutionary economic policies
which had a deep impact on the UK economy. In the early
years of the 1980s, Mrs Thatcher embarked on a policy of
Monetarism. This involved trying to target the money supply
to reduce inflation by increasing interest rates sharply.
Ronald Reagan's death in June 2004 prompted numerous
reviews of his legacy, especially is foreign, tax, and budget
policies. But little attention was paid to the success of his
monetary policy. Yet President Reagan viewed reducing
inflation through slower growth of monetary aggregates as
equally important to his tax, budget and regulatory policies.
This made Reagan’s presidency unique because no other
American president, before or after, has made monetary
policy so central to his economic policy objectives. Not only
did his policy end the "Great Inflation" but it provided a new
direction for the successful pursuit of price stability over the
past quarter century, in the United States and abroad.
The Fed Chairs
Three Fed chairs in a row had Monetarist leanings, but this has apparently ended.
Paul Volcker
Took tough steps of raising
interesting rates in early 80s to
stem inflation; recently known
for the Volcker Rule against
banks speculating with
depositor money
Alan Greenspan
Ran the Fed successfully for 16
years and then . . . Critics
claim that during his last 3
years, he kept rates too low,
triggering housing bubble. He
claims now that he made the
mistake of thinking that banks
would limit their lending risk
out of self-interest.
Ben Bernanke
An academic who studied
the Great Depression. Took
extraordinary steps during
financial crisis to prevent
another GD. Expanded
powers of Fed. Promoted
transparency.
CHAIRMEN (terms):
Paul Volcker (1979-1987)
Alan Greenspan (1987-2006, 19 yrs!)
Ben Bernanke (2006-2014)
Janet Yellen, (2/1/2014 - ??)
Janet Yellen
Legacy: who knows?
Will likely tend to
follow the policies of
Bernanke, but clearly
favors Keynesian view.
Paraphrased Excerpts from Letter to Shareholders
(10/30/14):
Yesterday was an important day. It marked the end of
the Fed’s experiment in economic stimulus (QE),
which originally was meant to be a one-time injection
to a financial system in shock (Fall/08) but has, over
the last six years, tried to remedy such things as labor
and housing markets . . .
Megan Clubb
Board Member of San Fran Fed
CEO/Chair of Baker Boyer National Bank
Walla Walla, Washington
Despite the end of QE, the Fed plans to continue its
low-interest rate policy for a considerable time. I have
written to you many times about the negative impact
these low interest rates are having . . . The Fed needs
to do more than end QE. It must allow interest rates
and economic markets to return to normal. The
current Fed policy of keeping rates artificially low is
driving community banks out of business . . .
Is Megan Clubb a monetarist or Keynesian?
Basic Monetary Policy
Stimulative Monetary
Policy
Fed
Buys Treasury
Securities
$
Investors
Bank Funds
Increase
Interest Rates
Decrease
Aggregate
Spending
Increases
Inflation
Increases
Bank Funds
Decrease
Interest Rates
Increase
Aggregate
Spending
Decreases
Inflation
Decreases
Restrictive Monetary
Policy
Fed
Sells TSecurities
$
Investors
Monetary Policy Goals
 Goals of the Monetary Policy
 Steady economic growth
Keynesians focus more heavily
on these goals
 Low unemployment
 Stable prices (low inflation) Monetarists say this is most important because
the others goals cannot be achieved without this.
 Tradeoffs
 Growth & Employment: these can be achieved simultaneously – directly
related – no FOMC controversy.
 Employment & Low Inflation: negatively related (teeter-totter, Phillip’s Curve)
– FOMC members will seldom agree about these two conflicting goals
 Raising employment by growing the economy may increase inflation (e.g.
recessions during early 1990 and 2001-2004)
 Lowering inflation by slowing the economy may increase unemployment (e.g. 20052006)
 “Take away the punch bowl just when the party is getting good,” (famous quip by
longest serving Fed Chair Bill Martin, 19 years, in early 1900s)
Phillips Curve
Employment/Inflation Tradeoff, Phillips Curve, 1960s
Indicators Monitored by the Fed
 Indicators of economic growth
 Gross Domestic Product or GDP (total value of goods
and services produced)
 Other indicators: National income, unemployment,
demand for cardboard boxes, etc.
See http://research.stlouisfed.org/fred2/categories/18
 Indicators of Inflation
 Consumer Price Index – Urban (all items at retail level).
See www.inflationdata.com
 Producer price index, prices at wholesale level
 Also wage rates, oil and gold (tends to move with CPI)
Indicators Monitored by the Fed
 Leading Indicators: Used to predict future (leading index
consists of 10 indicators, 3-mo. movement indicates turning point)
• The United States Department of Labor’s monthly report on the unemployment rate, average
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hourly earnings and the average workweek hours from the Employment Situation report
The United States Department of Labor’s weekly report on first-time claims for state
unemployment insurance
The Census Bureau’s monthly consumer goods and materials report from the Preliminary Report
on Manufacturers' Shipments, Inventories, and Orders
The Census Bureau’s monthly non-defense capital goods report from the Preliminary Report on
Manufacturers' Shipments, Inventories, and Orders
The Census Bureau’s monthly report on building permits from the Housing Starts and Building
Permits report
The difference (spread) between the interest rates of 10-year Treasury notes and the federal
funds rate
The Federal Reserve's inflation-adjusted measure of the M2 money supply
The Institute for Supply Management’s monthly ISM Index of Manufacturing including: supplier
deliveries, imports, production, inventories, new orders, new export orders, order backlogs,
prices and employment.
The S&P 500
The University of Michigan Consumer Sentiment Index's consumer expectations
Indicators Monitored by the Fed
 Coincident Indicators: Simultaneous to economic cycle
• Number of employees on non-agricultural payrolls
• Personal income less transfer payments
• Industrial production
• Manufacturing and trade sale
 Lagging Indicators: Occur a few months after cycle
• The average duration of unemployment (inverted)
• The value of outstanding commercial and industrial loans
• The change in the Consumer Price Index for services
• The change in labor cost per unit of output
• The ratio of manufacturing and trade inventories to sales
• The ratio of consumer credit outstanding to personal income
• The average prime rate charged by banks
Lags in Monetary Policy
 Controlling economy is very difficult for Fed because
of lags
 Much like driving car blindly or with 5-second delayed
vision
 Recognition lag
 Time between when problem occurs and when it is
recognized. (Stats are only measured periodically.)
 Implementation lag
 How quickly Fed acts to implement change in monetary policy
 Fiscal policy via Congress takes much longer
 Impact Lag
 Takes time for monetary changes to have full impact
Playing the Fed Chair Game
Go to http://www.frbsf.org/education/activities/chairman/
Keep playing until you are reappointed!
For example of Fed Minutes analysis (go to 4 minutes or so)
https://www.youtube.com/watch?v=1YzDCGrbZHU
Forecasting Money Supply Movements
 Fed is most concerned with meeting L/T targets in money
supply (M1, M2) rather than S/T targets
 Improved communication at the Fed
 Prior to 1999, Fed waited several weeks to disclose its decisions
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but now Fed provides immediately disclosure
Speculation of Fed’s intention by financial markets caused
undesired volatility
Now Fed discloses its decisions immediately after meeting
Fed attempts to prime the markets by providing indications of its
“bias” on rates
Starting in Dec/08, Fed gives a target range for Fed Fds Rate
rather than a specific rate.
Fed recently announced more clear disclosure of its intentions
Assessing the Impact of Monetary Policy
 Anticipating reported money supply levels
 Every Thursday, money supply data is released
 Because investors and financial market professionals cannot profit
on information available to everyone at the same time, they must
try to forecast and anticipate changes to react before others
 E.g. Bond portfolio manager knows bond prices move inversely
with rates. Will try to stay one move ahead of the Fed.
Integrating Monetary and Fiscal Policies
 History
 Executive branch usually most concerned with employment and
growth. WHY?
 Fed and executive branch may differ on priorities of price stability
or growth needs
 They will usually agree when inflation and unemployment are at
relatively low levels
Monetizing the Debt
 Should the Fed help finance a federal budget deficit
created by fiscal policy?
 With a big budget deficit, the US Treasury Dept. must sell T-
securities, taking funds out of the money supply, which places an
upward pressure on interest rates.
 To compensate, the Fed itself could purchase T-securities (like any
investor). The Treasury now owes the Fed. major bucks. (Robbing
Peter to pay Paul!)
 Treasury Dept. likes monetizing the debt, because it helps keeps
interest rates down and the economy up.
 But others might not like monetizing the debt because it could ignite
inflation if the economy grows too fast.
 Why are so many in the U.S. and abroad opposed to
quantitative easing by the U.S. Fed?
Global Effects on Monetary Policy
 Impact on the U.S. dollar
 Weak Dollar
 A weak dollar stimulates U.S. exports, discourages imports and
stimulates certain sectors of the economy
 May cause inflationary pressure because imports are more
expensive which allow domestic prices to rise also
 Foreign investors may pull money out, putting upward pressure
on interest rates
 Fed less likely to stimulate the economy if the dollar is weak
(allow interest rates to increase)
 Strong dollar
 Stimulates imports, reduces inflation because of cheap imports
 Dampens economic growth overall
 Fed more likely to use stimulate policy
Global Effects on Monetary Policy
 Transmission of interest rates
 Global capital and money markets are integrated
 Deficits or surpluses in the U.S. Gov’t have global implications
 Global Crowding Out: Barring other factors, US budget deficits
cause higher U.S. interest rates, which attract foreign investment,
which causes a decrease in supply of foreign funds, which causes
foreign interest rates to increase as well
Impact of Greece on European Monetary Policy
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Greece experienced a weak economy and a large budget deficit, reach a
crisis in the spring of 2010, and again in the winter of 2015.
Creditors are less willing to lend to the Greece government because they
fear that the government may be unable to repay the loans.
The European Central Bank (ECB) was forced to use a more stimulative
monetary policy than desired in order to ease concerns about the Greek
crisis, even though this caused other concerns about potential inflation in the
Eurozone.
Now the most important member of the EU, Germany, is balking at bailing
out Greece again and appears willing to allow Greece to leave the EU,
which would create turbulence.