money and monetary policy - university of california, berkeleyolney/presentations/monetary policy...

Economic Forces in American History

Money and Monetary Policy


2

Money & Monetary Policy: Outline

Central Banks

Macroeconomic Models

Monetary Policy in Modern Economies

Martha Olney (U.C. Berkeley)

[email protected]


Central Bank

A Bankers’ 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

1791-1811 for First B.U.S.

1816-1836 for Second B.U.S.

Regulated commercial banks

Politically unpopular

power concentrated in one institution


From 1836 to 1913

Free Banking Era, 1836-1864

National Bank Acts of 1863 & 1864

Financial Panics

1870s, 1880s, 1890s, 1907

5


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


The Fed districts & banks


8

New Deal Legislation, 1933-1936

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Repealed 1999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)


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


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


What distinguishes the models?

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

Quantity Theory

Simplification:

Think about entire economy at once

Assumptions:

1. Velocity stable

2. Real GDP equals potential

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


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


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%


Velocity is neither constant


. . . Nor stable


Can use MV=PY to explain hyperinflation

Hyperinflation: when prices increase >20% per month

Milton Friedman: “Hyperinflation is always and everywhere a monetary phenomenon.”


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

more people unemployed

With more unemployment,

Wage increases are smaller (or, wages fall), and thus

Price increases are smaller (or, prices fall)

18


Monetary Policy

Fed must choose

or

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

Target the

money supply

Target interest

rates


Macroeconomy & Monetary Policy

The Fed targets interest rates in reaction to inflation & unemployment

To fight inflation, the Fed creates unemployment

Output

(GDP) Employment

Aggregate

Demand

Unemployment

Inflation Interest

Rates


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


22


Original Phillips Curve

Found:

tradeoff between unemployment and wage inflation

Story:

Bargaining power

23

A.W. Phillips used U.K. data for 1861-1957


Phillips Curve (U.S. version)

Tradeoff between unemployment and price inflation

“This shows the menu of choice…”

24


Phillips Curve

25


Phillips Curve Shifts

Inflationary expectations

Productivity growth rate

Cost shocks due to lower supply (corn, oil)


28


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


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


32

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


33

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


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



Federal Funds Rate 2007-2010

What changes first:

The Target Rate or The Actual Rate?

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

5.5

6

1/1/0

7

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

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

Actual

Target

August 9 2007:

European

Central Bank

says “The

Emperor (and

his subprime

MBS) Has No

Clothes!”

Sept 18 2008: Bernanke

& Paulson pull the

financial fire alarm in the

Bush White House

Dec 16 2008:

How low can

you go?


Yield Curve

Yield Curve shows, for any one day, the short-term and long-term interest rates

36


Yield Curve

What if Fed changes short-term rates and long-term rates don’t change?

Problematic, because it’s long-term rates that affect spending

“Operation Twist”

37


What if Banks Hold Excess Reserves?

38

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10

Billions o

f D

ollars

Source: Board of Governors of the Federal Reserve System/FRED

Excess Reserves of Depository Institutions


Lending is still below 2008 peak

39

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10

Billions o

f D

ollars

Source: Board of Governors of the Federal Reserve System/FRED

Commercial and Industrial Loans at All Commercial Banks


Counterfactual

To evaluate any policy compare the policy’s results with what would have been in the absence of the policy

Yesterday

(before the policy) Today

(with the policy) NOT vs.

What today

would have

been like

without the

policy

Today

(with the policy)

BUT instead vs.

money and monetary policy - university of california, berkeleyolney/presentations/monetary policy...

Documents