Lecture 22 Liquidity Trap Hyperinflation Monetary Policy. Noah Williams

Transcription

1 Lecture 22 Liquidity Trap Hyperinflation Monetary Policy Noah Williams University of Wisconsin - Madison Economics 702

2 Limitations on Stabilization & Liquidity Traps Generally have monetary policy smooth cyclical fluctuations. Fiscal policy takes longer to implement, money is more direct. Limitation on monetary policy: nominal interest rates are bounded at zero. Can t set nominal interest rates negative: everyone would want to borrow. Means LM curve very flat near zero interest rates. So increases in money supply have little effect at low rates: a liquidity trap. Very relevant for many economies: Japan, US, Europe. From 1960 to 1990, Japan s economy grew over 6% per year. But the Japanese economy slumped in the 1990s, with growth near zero. Stock and land prices fell from excessive levels, hurting banks. Banks financial distress caused lending to fall, reducing investment.

3 Growth in Interest Rates in Japan Japan: Annualized Growth of Real GDP, Japan: Money Market Inerest Rate,

4 r=r IS IS FE LM(P) Shock r* 0 Y Y* A Liquidity Trap: Increase in M Powerless

5 Policy in a Liquidity Trap Interest rates near zero and remained there. Low inflation or even deflation, so real rates also near zero. Possible to run expansionary fiscal policy to shift IS curve to restore equilibrium. Was tried but unsuccessful some say it wasn t enough. In combination with expansionary Problem with monetary policy is zero (expected) inflation. If could engineer an inflation, then possible to have equilibrium with negative real rates but positive nominal (Krugman). Also no reason to force households to consume. Not clear how to commit to it most central banks like Bank of Japan known inflation fighter. Possible to do so by depreciating currency (Svensson).

6 r=r IS IS FE LM(P) Shock G increase r* 0 Y Y* A Liquidity Trap: Fiscal Policy

7 r IS IS FE LM LM R=r+i Shock r* 0 i r <0 Y Y* 0 A Liquidity Trap: Increase Inflation

8 US Policy Recently Fed has recently raised interest rates after having kept them at near zero for extended period of time. Fed has also backed away from explicit short-term inflation target, seeming to be willing to allow inflation to rise in short run. Has stressed that 2% inflation target is for the medium term. Fed has become more explicit recently, announcing forecast paths for future interest rates. (Dot plots) All of these steps geared toward guiding expectations, and committing to allowing inflation to rise. Inflation has remained low, but success of policy would require low rates even when inflation picks up. Given dissent on Board, in press, profession, not clear this would happen. Others have argued that Fed should raise inflation target as long as economy remains below trend growth. Potential problem on how to reduce inflation once it takes hold.

9 Monetary Policy Conduct of monetary policy may have dramatic implications for economic outcomes. Main example in US: The Great Inflation of the 1970s. Sustained double digit annual inflation rates, accompanied by slow economic growth and recession. Problems on much larger scales internationally. Hyperinflations in Latin America in 1980s had annual inflation rates in hundreds to thousands of percents. Bolivia: 1281% (1984), 11,750% (1985), 276% (1986). Argentina and Brazil in hundreds of percents. Other hyperinflation examples: Hungary 1946, Zimbabwe

10 Argentina: Inflation and Real Money 2 7 Real balances Log value of monthly gross inflation rate 1 0 Inflation 6 5 Log value of real (base money) balances

11 Brazil: Inflation and Real Money 1 8 Real balances Inflation Log value of gross inflation rate 0 6 Log value of real (base money) balances

12 Highest Monthly Inflation Rates in History Country Month Monthly rate Daily Doubling Time Hungary July % 207% 15 hours Zimbabwe Nov % 98 % 24.7 hours Yugoslavia Jan % 64.6% 1.4 days Germany Oct ,500 % 20.9% 3.7 days Greece Oct ,800% 17.9 % 4.3 days China May ,178 % 11 % 6.7 days

13 German Hyperinflation

14 Zimbabwe Hyperinflation

15 Zimbabwe Hyperinflation Most recent hyperinflation episode was Zimbabwe. Official inflation rates: : %. 2005: %, 2006: 1,281.11%, 2007: 66,212.3% 2008: 231,150,888.87%. Even higher during late 2008 Problem began with land reforms (land confiscation), leading to collapse in output. In early 2006, government printed ZW$21 trillion to pay of IMF loans. In May 2006, printed additional $60 trillion to fund police, military salaries. Value of currency began to collapse. New currencies in 2006, 2007, Chop off zeros. From January to December 2008, the money supply growth rose from 81,143% to 658 billion percent.

16 Zimbabwe Currency August 2006: New dollar = 1000 old dollars New ZW $1000 = $1.50 US

17 Zimbabwe Currency Jan : ZW$10 million = $1.66 US

18 Zimbabwe Currency Jul : ZW$100 billion = $0.13 US

19 Zimbabwe Currency Aug. 1, 2008: New currency ZW$10 billion = ZWR$1 New ZWR $100 trillion = ZW$10 14 = ZW$10 27 pre-2006 New ZWR $100 trillion = $300 US on 1/1/09, $30 US on 1/16 Now selling on ebay as collector s item.

20 Zimbabwe Exchange Rates In terms of new currency (ZWR): Date New ZWR per USD Sept ,000 Oct ,000 Nov ,200,000 Mid Dec ,000,000 End Dec ,000,000,000 Mid Jan ,000,000,000,000 Feb ,000,000,000,000 Foreign currency (US $, S. African Rand) effectively legalized as of Sept. 2008, officially in Jan Zimbabwe currency suspended in April 2009.

21 Zimbabwe Exchange Rates In terms of original currency

22 Inflation and Seignorage Hyperinflations largely an issue of government finance. Seignorage: government revenue from creation of money. Consider money demand where inflation equal to expected, real interest rate and output constant: M P = L( r + π, Ȳ ) where π = Ṁ /M growth of money=inflation rate. Seignorage S given by real increase in money: S = Ṁ P = Ṁ M MP = π M P Seignorage is the inflation tax: revenue = tax rate (π) times base M /P.

23 Laffer Curve Substituting back money demand: S = πl( r + π, Ȳ ) How does seignorage revenue depend on inflation rate? S π = L( r + π, Ȳ ) + πl R( r + π, Ȳ ) L > 0 but L R < 0. For small π first term dominates, and S π > 0. For large π, S π < 0. Hence get a Laffer curve Cagan (1956) studied hyperinflations, used a particular functional form: log M P = a br + log Y hence S π = B(1 bπ) exp( bπ). Maximal level S.

24 Figure 15.07a The determination of real seignorage revenue Abel/Bernanke, Macroeconomics, 2001 Addison Wesley Longman, Inc. All rights reserved

25 Figure 15.07b The determination of real seignorage revenue Abel/Bernanke, Macroeconomics, 2001 Addison Wesley Longman, Inc. All rights reserved

26 Figure The relation of real seignorage revenue to the rate of inflation Abel/Bernanke, Macroeconomics, 2001 Addison Wesley Longman, Inc. All rights reserved

27 Laffer Curve Even moderate seignorage needs can lead to high inflation. 10 Laffer Curve 9 8 Seignorage Revenue in Percent of GDP Inflation Rate in Percent

28 Seignorage Revenue: Argentina 0.3 Seigniorage: ratio of Diff money to nominal gdp

29 Seignorage Revenue: Brazil 0.05 Seigniorage: ratio of Diff money to nominal gdp

30 Seignorage and Hyperinflation If seignorage revenue maximized at hundreds of percents (or lower), why have we seen even higher inflation rates? Cagan s answer: gradual adjustment of expected inflation and money holdings. Assume r and Y are constant so desired real money holdings are: ˆm = exp(a b(r + π))y = B exp( bπ) Suppose actual real money holdings m adjusts toward desired: ṁ m = φ [log ˆm(t) log m(t)] = β [log B bπ(t) log m(t)] This is a partial adjustment model, perhaps due to adaptive expectations, where φ governs the speed of adjustment

31 Hyperinflations No longer have inflation equal to expected inflation. So π = S/m ṁ m ṁ = Ṁ P M P 2 Ṗ = Ṁ M P M M P ṁ m = Ṁ M π S = Ṁ P = Ṁ P M M = m Ṁ M substitute in and solve: Ṗ P [ ṁ m = φ log B b( S m ṁ ] m ) log m(t) [ φ = log B b S(t) ] 1 bφ m(t) log m(t)

32 Dynamics of Money and Inflation The evolution of real money is: ṁ m = φ [ log B b S(t) ] 1 bφ m(t) log m(t) As long as S < S there are two steady states m: ṁ m = 0 m = B exp( b S m ), π = S m If in a lower m steady state where S < S but then a shock to money demand hits, will converge to the higher m steady state. That is, the high m, low π steady state is stable.

33 Dynamics of Hyperinflation 0.5 S=.08 S=.12 0 Change in Log Real Money Holdings Log Real Money Holdings

34 Hyperinflation Suppose economy initially in a steady state where required seignorage is less than S. But then required S increases to more than S. If there were immediate adjustment, this equilibrium would not be sustainable. But with partial adjustment, this implies ever accelerating inflation and money growth and declining real balances. In Germany after WWI, inflation reached 322% per month, but Cagan estimated the inflation rate that maximizes seignorage at only 20% per month.

35 The Federal Reserve System Monetary policy in US administered by the Federal Reserve. Leadership of the Fed is provided by the Board of Governors in Washington, D.C. 7 governors, appointed by the President, and have 14-year terms. Chairman of the Board of Governors has considerable power, and has a term of 4 years. Monetary policy decisions are made by the Federal Open Market Committee (FOMC): consists of the 7 governors plus 5 presidents of the Federal Reserve Banks on a rotating basis (with the New York president always on). FOMC meets eight times a year, may meet more.

36 FRB: Federal Reserve Districts and Banks The Twelve Federal Reserve Districts Addresses and phone numbers Banks Branches Boston New York Philadelphia Cleveland Richmond Atlanta Chicago St. Louis Minneapolis Kansas City Dallas San Francisco Board The Federal Reserve officially identifies Districts by number and Reserve Bank city. In the 12th District, the Seattle Branch serves Alaska, and the San Francisco Bank serves Hawaii. The System serves commonwealths and territories as follows: the New York Bank serves the Commonwealth of Puerto Rico and the U.S. Virgin Islands; the San Francisco Bank serves American Samoa, Guam, and the Commonwealth of the Northern Mariana Islands. The Board of Governors revised the branch boundaries of the System in February Home About the Fed Accessibility Contact us Last update: December 13, 2005

37 Fed Balance Sheet Traditionally, largest asset was holdings of Treasury securities, also owns gold, makes loans to banks, and holds other assets including foreign exchange and federal agency securities. Largest liability is currency outstanding. Another liability is deposits by banks. Fed makes profit on security portfolio, which it pays to Treasury. In 2015 transferred $97.7 billion to Treasury. In response to financial crisis and recession of 2007-present, balance sheet of Fed has expanded to include wide array of assets, direct bank lending, and mortgage-backed securities.

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39 Fed Policy Instrument Main instrument of conventional policy is the Federal Funds rate. An extremely short-term interest rate: the rate on overnight loans from one bank to another. Uses as implicit means of changing money supply. Policy carried out via open market operations by trading desk at New York Fed. Buy and sell government securities so that market for overnight cash clears at the target rate. Again in response to recent crisis and recession, direct lending and other purchases of assets have become an important component of policy response. Unconventional monetary policy.

40 Policy Interest Rates Discount Rate (DISCONTINUED) Primary Credit Rate Federal Funds Target Range - Upper Limit Federal Funds Target Range - Lower Limit Federal Funds Target Rate (DISCONTINUED) (Percent) research.stlouisfed.org

41 Other Policy Instruments Also can adjust reserve requirements, minimum fraction of each type of deposit that a bank must hold as reserves. Discount window lending: lending reserves to banks so they can meet depositors demands or reserve requirements, interest rate on such called the discount rate, role of lender of last resort. A discount loan increases the monetary base, increases in discount rate discourage borrowing, reduce the monetary base. In past, Fed discouraged banks from borrowing from the discount window. Instead, banks borrow from each other in the Federal funds market. Interest rate is the Fed funds rate. In recent years has encouraged discount window borrowing.

42 1 Discount Window includes primary, secondary and seasonal credit programs. Federal Reserve Bank of New York December 2008 Forms of Federal Reserve Lending to Financial Institutions Term Securities Single-Tranche Term Discount Term Auction ABCP Money Money Market Term Asset-Backed Primary Dealer Transitional Credit Reciprocal Currency Term Securities Commercial Paper Discount Securities Lending Facility OMO Program Window Program Facility Market Fund Investing Funding Securities Loan Credit Facility Extensions Arrangements Lending Facility Funding Facility Regular OMOs Window 1 Lending Options Program 4 Liquidity Facility Facility Facility 5 (announced (announced (announced (announced (announced (first announced (announced (announced (announced (announced (announced (announced March 7, 2008) August 17, 2007) December 12, 2007) March 16, 2008) 2 September 21, 2008) December 12, 2007) 3 March 11, 2008) 2 October 7, 2008) July 30, 2008) September 19, 2008) 2 October 21, 2008) November 25, 2008) U.S. and London brokerdealer subsidiaries of bank holding companies, Eligible Money Market All U.S. persons that Select central banks Despository institutions, Who can Depository Primary credit-eligible Primary credit-eligible participate? Primary dealers Primary dealers Primary dealers to lend on to banks Primary dealers Primary dealers institutions depository institutions depository institutions Goldman Sachs, Morgan Primary dealers U.S. branches and agencies Eligible CP issuers 6 Mutual Funds 7 own eligible collateral in their jurisdiction Stanley, Merrill Lynch 3 of foreign banks What are they Funds and Funds Funds Funds Funds Funds Funds Funds U.S. Dollars U.S. Treasuries U.S. Treasuries U.S. Treasuries Funds Funds Funds borrowing? subordinated note U.S. Treasuries, Full range of Schedule 1: U.S. Treasuries, U.S. Treasuries, Central banks pledge foreign Newly issued 3-month U.S. dollar-denominated Full range of What collateral agencies, Full range of Full range of Full range of Discount Window agencies, agency MBS Schedule 2 unsecured and assetbacked CP from eligible U.S. dollar-denominated certificates of deposit, bank Recently originated currency and lend against agencies, Discount Window U.S. Treasuries can be pledged? agency MBS, Discount Window Discount Window tri-party repo collateral First-tier ABCP notes and commercial paper eligible collateral in but typically collateral collateral collateral system collateral 9,10 Schedule 2: Schedule 1 plus all TSLF collateral agency MBS 8 issued by highly rated and tri-party repo their jurisdiction U.S. issuers AAA ABS 11 invesment grade debt securities agency MBS system collateral 10 9 financial institutions Is there a No (loans are No (loans are No (loans are reserve impact? Yes Yes Yes Yes Yes Yes Yes Yes Yes bond-for-bond) bond-for-bond) bond-for-bond) Yes Yes Yes Typically overnight, What is the Typically, term is Typically ABCP maturity date 28 days but up to Up to 90 days days or 84 days 13,16 Overnight 28 days term of loan? overnight 14 days Overnight Overnight Overnight to 3 months 13 2 weeks or less several weeks 17 (270-day maximum) 3 months N/A At least one year 14 Is prepayment allowed if term No No Yes Yes No N/A N/A No N/A No No No N/A N/A Yes is greater than overnight? Which Reserve Banks conduct FRBNY FRBNY All All All FRBNY FRBNY FRBNY FRBNY FRBNY FRBNY FRB Boston FRBNY FRBNY FRBNY operations? How frequently Typically on schedule with FRBNY Schedule 1: Every other As requested Every other week, (standing facility) or as necessary Daily week is the program Typically once As requested As requested As requested TAF auctions or as requested As requested As requested As requested Typically weekly As necessary accessed? or more daily (standing facility) 16 (standing facility) (standing facility) 18 Monthly by central banks Schedule 2: Weekly (standing facility) (standing facility) (standing facility) Where are Temporary statistics reported OMO activity 19 publicly? Temporary H Factors H Factors OMO activity 19 Affecting Reserve Affecting Reserve Balances 20 Balances 20 TAF Activity 19 H Factors Affecting Reserve Balances 20 H Factors Affecting Reserve Balances 20 H Factors Affecting Reserve Balances 20 Securities lending activity Term securities lending facility activity 19 Term securities lending facilty options program activity 19 H Factors Affecting Reserve Balances 20 H Factors Affecting Reserve Balances 20 H Factors Affecting Reserve Balances 20 TALF activity 19 2 The PDCF, TSLF and AMLF will remain in operation through April 30, 2009 as announced on December 2, ECB and SNB created December 12, 2007; BOC, BOE, and BOJ created September 18, 2008; RBA, Sveriges Riksbank, DNB, and Norges Bank created September 24, 2008; Reserve Bank of New Zealand created October 28, 2008; Banco Central do Brazil, Banco de Mexico, Bank of Korea, and Monetary Authority of Singapore created October 29, TOP auctions are sales of options granting the right to enter into TSLF borrowing. 5 The TALF is expected to go live around February The Federal Reserve reserves the right to review and make adjustments to these terms and conditions including size of program, pricing, loan maturity, and asset and borrower eligibility requirements consistent with the policy objectives of the TALF. 6 Through the CPFF the FRBNY provides financing to an SPV that purchases eligible three-month unsecured and asset-backed commercial paper from eligible issuers. 7 Through the MMIFF the FRBNY will provide senior secured funding to a series of private sector SPVs to finance the purchase of certain money market instruments from eligible investors. 8 Reverse repos are collateralized with U.S. Treasuries. 9 PDCF and TSLF collateral expanded on September 14, Includes non-u.s. dollar denominated securities. 11 Includes auto loans, student loans, credit card loans, or small business loans guaranteed by the U.S. SBA 12 Open market operations are authorized for terms of up to 65 business days day and 84-day terms may vary slightly to account for maturity dates that fall on Bank holidays. 14 Primary credit loans are generally overnight. Loans may be granted for term beyond a few weeks to small banks, subject to additional administration. 15 Maximum maturity of term increased from overnight to 30 days on August 17, 2007, and to 90 days on March 16, Foward selling TAF auctions announced on September 29, 2008 will be conducted in November with terms targeted to provide funding over year-end. 17 Loans are targeted to span potentially stressed financing dates, such as quarter-ends. 18 TOP auctions may be conducted on multiple dates for a single loan and may be conducted well in advance of a loan period. 19 Data only available on days when operations are conducted. 20 Data published on Thursday, as of close of business on Wednesday.

43 Policy Decisions and Conduct FOMC meets 8 times per year to set target rate. Directives from Congress to pursue price stability and full employment. Prior to meetings intensive staff briefings, laying out policy options, scenarios, and likely effects. For many years the Fed resisted committing to an explicit inflation target. Now explicitly 2%. Many other central banks around the world explicitly announce inflation targets, target interest rate paths.

44 Last Update: March 21, 2018 PDF March 21, 2018 Federal Reserve issues FOMC statement For release at 2:00 p.m. EDT Share Information received since the Federal Open Market Committee met in January indicates that the labor market has continued to strengthen and that economic activity has been rising at a moderate rate. Job gains have been strong in recent months, and the unemployment rate has stayed low. Recent data suggest that growth rates of household spending and business fixed investment have moderated from their strong fourth-quarter readings. On a 12-month basis, both overall inflation and inflation for items other than food and energy have continued to run below 2 percent. Market-based measures of inflation compensation have increased in recent months but remain low; survey-based measures of longer-term inflation expectations are little changed, on balance. Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The economic outlook has strengthened in recent months. The Committee expects that, with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace in the medium term and labor market conditions will remain strong. Inflation on a 12-month basis is expected to move up in coming months and to stabilize around the Committee's 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely. In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1-1/2 to 1-3/4 percent. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation. In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data. Voting for the FOMC monetary policy action were Jerome H. Powell, Chairman; William C. Dudley, Vice Chairman; Thomas I. Barkin; Raphael W. Bostic; Lael Brainard; Loretta J. Mester; Randal K. Quarles; and John C. Williams. Implementation Note issued March 21, 2018

45 Release Date: December 16, 2008 For immediate release The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent. Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further. Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters. The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgagebacked securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity. Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco. The Board also established interest rates on required and excess

46 Figure 1. Medians, central tendencies, and ranges of economic projections, and over the longer run Percent Change in real GDP Median of projections Central tendency of projections Range of projections 3 Actual Longer run Percent Unemployment rate Longer run Percent PCE inflation Longer run Note: Definitions of variables and other explanations are in the notes to the projections table. The data for the actual values of the variables are annual.

47 Figure 2. FOMC participants assessments of appropriate monetary policy: Midpoint of target range or target level for the federal funds rate Percent Longer run Note: Each shaded circle indicates the value (rounded to the nearest 1/8 percentage point) of an individual participant s judgment of the midpoint of the appropriate target range for the federal funds rate or the appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run. One participant did not submit longer-run projections for the federal funds rate.