Money and Monetary Policy. Economic Forces in American History

Transcription

1 Money and Monetary Policy

2 Money & Monetary Policy: Outline Central Banks Macroeconomic Models Monetary Policy in Modern Economies Martha Olney (U.C. Berkeley) 2

3 A Bankers bank Central Bank Usually established by the government Degree of independence varies Functions Lender of last resort When banks would otherwise fail, they can borrow from the central bank Regulator of commercial banks Though other agencies may do this, too Conducts monetary policy Affecting economic growth & inflation 3

4 First & Second Banks of the U.S. Central banks Established by Congress Limited 20-year charters for First B.U.S for Second B.U.S. Regulated commercial banks Politically unpopular power concentrated in one institution 4

5 From 1836 to 1913 Free Banking Era, National Bank Acts of 1863 & 1864 Financial Panics 1870s, 1880s, 1890s,

6 Federal Reserve Act of 1913 Panic of 1907 Lots of banks closed due to runs Reignited call for a central bank Federal Reserve Banks established Fractional reserve system Reserves held at 12 regional F.R. banks Permanent charter No unified monetary policy until 1930s Weak Board of Governors 6

7 The Fed districts & banks

8 New Deal Legislation, Response to problems of Great Depression Federal Open Market Committee established Policy-making body One voice rather than regional policies Glass-Steagall Act Forbade banks from also offering investment advice Repealed 1999 Bank deposit insurance system (FDIC) created Paying interest on deposits banned in banks Allowed but regulated heavily in thrifts (S&L s) 8

9 The Fed Federal Reserve Board (7 people) Chairman Ben Bernanke Federal Open Market Committee Board plus 5 Federal Reserve Bank Presidents Mission: a dual mandate (employment and inflation)... conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates

10 What determines the inflation rate? Three macro models address this question 1. Quantity Theory of Money 2. AS/AD model 3. Monetary Policy Approach 10

11 What distinguishes the models? Quantity Theory Simplification: Think about entire economy at once Assumptions: 1. Velocity stable 2. Real GDP equals potential AS/AD Model Simplification: Divide economy into households, businesses, government, rest of world Assumption: Central bank targets money supply, lets interest rates change as need be Monetary Policy Simplification: Divide economy into households, businesses, government, rest of world Assumption: Central bank targets interest rates, lets money supply change as need be

12 Quantity Theory of Money Simple equation; frequent misinterpretation M V = P Y money supply * velocity of money = price level * real GDP M V = P Y is always true because V = PY / M Equivalent to %ΔM + %ΔV = %ΔP + %ΔY 12

13 If both M & V change, M tells us nothing Quantity Theory not useful for explaining short-run (year-to-year) changes in inflation, especially in recession Suppose Money growth rate = 5% Velocity growth rate = 2% Real GDP growth rate = 3% Suppose instead Money growth rate = 15% Velocity growth rate = -12% Real GDP growth rate = 3%

14 Velocity is neither constant

15 ... Nor stable

16 Can use MV=PY to explain hyperinflation Hyperinflation: when prices increase >20% per month Milton Friedman: Hyperinflation is always and everywhere a monetary phenomenon.

17 Macroeconomics, in 1 slide Businesses produce what will be sold So aggregate demand matters Aggregate Demand is Consumption + Investment + Government + (Exports Imports) Less aggregate demand leads to less output produced, and thus fewer people employed, and thus With more unemployment, more people unemployed Wage increases are smaller (or, wages fall), and thus Price increases are smaller (or, prices fall) 18

18 Fed must choose Monetary Policy Target the money supply or Target interest rates Can t independently do both Since 1982, Fed targets interest rates Since 2008, at zero lower bound so expanding reserves Going forward: Fed tool will be interest rate paid on excess reserves 19

19 Macroeconomy & Monetary Policy The Fed targets interest rates in reaction to inflation & unemployment To fight inflation, the Fed creates unemployment Unemployment Aggregate Demand Output (GDP) Employment Inflation Interest Rates

20 Inflation Hawks and Doves Taylor Rule Fed reacts to inflation and unemployment Inflation hawk Puts very high cost on inflation; comfortable with high unemployment Inflation dove Puts high cost on inflation but not comfortable with high unemployment 21

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22 Original Phillips Curve A.W. Phillips used U.K. data for Found: tradeoff between unemployment and wage inflation Story: Bargaining power 23

23 Phillips Curve (U.S. version) Tradeoff between unemployment and price inflation This shows the menu of choice 24

24 Phillips Curve 25

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26 Inflationary expectations Phillips Curve Shifts Productivity growth rate Cost shocks due to lower supply (corn, oil)

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29 Recession. And Recovery? Recession began December 2007 Recovery began June 2009 Recovery is not the same as recovered Two Questions What caused the recession? Why the ambivalence about recovery? Will there be a second dip (a second recession)? 30

30 How it s supposed to work Fed goal: inflation rate 2-3 percent Fed targets federal funds rate Fed action affects government borrowing rate (going forward: Fed changes rate paid on excess reserves) Market forces determine long-term rates Exchange rates change Investment & net export spending respond Through multiplier, GDP changes Employment & unemployment change Impacting wages And changing inflation 31

31 Targeting an interest rate Fed sets target for an interest rate Takes action to influence that rate But market supply & demand determines rate Currently: Target is Federal funds rate (FF rate) Bank-to-bank overnight loans Bank requirement: reserves 10% of deposits Not enough reserves? Borrow from another bank More reserves in banking system? FF rate down Fewer reserves in banking system? FF rate up 32

32 So many interest rates Federal funds rate influences other interest rates Treasury rates Prime rate (for best commercial customers) Corporate bond rates Home mortgage rates Home equity loan rates And many other interest rates 33

33 Does Fed hit its interest rate target? Usually... But not during a financial crisis Going forward: When they change tools, this won t be an issue. The Fed will simply set the rate it pays on excess reserves. 34

34 Federal Funds Rate What changes first: The Target Rate or The Actual Rate? /1/0 7 August : European Central Bank says The Emperor (and his subprime MBS) Has No Clothes! Sept : Bernanke & Paulson pull the financial fire alarm in the Bush White House 4/2/0 7 7/2/0 7 10/1/ 07 12/3 1/07 3/31/ 08 6/30/ 08 9/29/ 08 12/2 9/08 Dec : How low can you go? 3/30/ 09 6/29/ 09 9/28/ 09 12/2 8/09 3/29/ 10 6/28/ 10 9/27/ 10 12/2 7/10 3/28/ 11 6/27/ 11 9/26/ 11

35 Yield Curve Yield Curve shows, for any one day, the shortterm and long-term interest rates 36

36 Yield Curve What if Fed changes short-term rates and longterm rates don t change? Problematic, because it s long-term rates that affect spending Operation Twist 37

37 Billions of Dollars What if Banks Hold Excess Reserves? 1,800 Excess Reserves of Depository Institutions 1,600 1,400 1,200 1, Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10 Source: Board of Governors of the Federal Reserve System/FRED 38

38 Billions of Dollars Lending is still below 2008 peak Commercial and Industrial Loans at All Commercial Banks 1,800 1,600 1,400 1,200 1, Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10 Source: Board of Governors of the Federal Reserve System/FRED 39

39 Counterfactual To evaluate any policy compare the policy s results with what would have been in the absence of the policy NOT Yesterday (before the policy) vs. Today (with the policy) BUT instead What today would have been like without the policy vs. Today (with the policy)