ECN202: Macroeconomics

1. 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."

2. 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.

3. 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” • “As Low Rates Depress Savers, Governments Reap Benefits” • “Low rates may do little to entice nervous consumers”

4. In the news • “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

5. In the news • “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”

6. A great invention? "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." "[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."

7. 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

8. 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

9. 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

10. 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?

11. Rate on US government debt with 10-year maturity Rate on 30-year mortgages – this impact housing demand

12. You can see that the 1970s was a problem

13. 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%.

14. 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?

15. 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.

16. 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

17. Default Risk Corporate debt is riskier = higher interest rate Corporate Aaa US 10-yr Treasury Municipal rate – lower because of tax benefits Municipal

18. International examples of default risk • Argentina Crisis of 1997-1998 • Asian Crisis (Hong Kong) of 1997 • Subprime Crisis of 2008 • Greece Crisis of 2009-2010

19. Argentina Crisis of 1997-98 Argentina Interest Rates

20. 2. Hong Kong Crisis of 1997

21. 3. Subprime Crisis of 2008 The default premium on corporate bonds increases in recession as investors worry about corporation’s ability to pay bills

22. 3. Subprime Crisis of 2008 Another view of same phenomenon – the gap between the two rates increases in uncertain/bad times

23. 4. Greece Crisis of 2009-2010 Investors get very worried about Greece

24. Maturity Risk 3-month is less risky than 10-year 10-yr 3-mth

25. Maturity Risk: Another view 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?

26. Inflation Risk You can see that interest rates are closely correlated with inflation rates. What happened in the late 1970s – and early 1980s? Inflation 3-yr Treasury

27. 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

28. Real Interest Rates Now look at those late 1970s and early 1980s. Who got “burned” in the late 1970s and who got burned in the early 1980s? 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.

29. A few things to know about interest rates (the price of money) 3.) interest rates are prices • Keynesian theory of money demand • 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

30. Interest rates are prices r* = interest rates ms* = money supply (M1) Ms Ms Md Md

31. 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

32. 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] * r* * r** Md m* m**

33. 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 * ** r* Md Md m** m*

34. 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 • Federal Reserve – control the S of cash (high-powered-money) Money Commercial Banks – control the amount of checking accounts issued Businesses & Households – they are the users of the money and decide what form of money they want to hold.

35. Money Supply Process Fed $s $s Banks Reserves $s Individuals & Businesses (Ms) Checking Account $s + Cash $s

36. Money supply Players 1. Federal Reserve (FED) • This institution controls the supply of high-poweredmoney (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 targetsby altering the money supply. 2.

37. Federal Reserve structure

38. Money supply Players 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 thecustomers with deposits want theirmoney back. Because banks wantto make as much profit as possiblethey will loan out as much money asthey can, which is why the Fed regulates how much the banks musthold as cash.

39. 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 high-powered-money (currency) supplied by the Fed and the paper receipts with checking accounts and you have the modern fractional reserve system.

40. 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. • Deposit insurance: deposits were guaranteed by the federal government, which eliminated bank runs • Bank examinations: the books of banks were regularly reviewed • 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) • Required reserves: banks must hold a percent of their outstanding deposits as cash – the required reserve rate

41. Money supply Players 3. Individuals and businesses • 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. Approach T-accounts

42. 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.

43. What affects the Money Supply? The factors affecting the money supply fall into two categories depending on the Fed’s control. Uncontrolled influences Controlled influences Now we will look at what would be included in these two

44. Uncontrolled influences on Money Supply • 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. • 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.

45. Controlled influences on Money Supply • 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. • Required reserve rate: If the Fed lowers the required reserve rate then the bank can lend out more which means an increase in Ms. • Discount rate: If the Fed raises the discount rate then it is discouraging banks from lending money, which reduces the Ms.

46. Fed policies to increase Money Supply If the Fed would like to increase the money supply then it would • OMO: it would buy Treasuries and pay for them with new $s that would expand the Ms. • Required reserve rate: the Fed would lower the rrr so banks could lend out more for any amount of reserves. • Discount rate: fed could lower the discount rate that encourages banks to borrow $s from the Fed to lend out and increase Ms.

47. 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. Interest rate money

48. Questions Get that piece of paper out and draw the appropriate diagrams 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)

49. Questions a. How do you show the impact on the money market of an economic expansion? Interest rate money

50. Questions b. How do you show the impact on the money market of the Fed’s decision to raise the discount rate?