Chapter 16 – Domestic and international dimensions of monetary policy

1. David Hume: Political theorist, mentor to Adam Smith, and early monetarist: “It seems a maxim almost self-evident, that the prices of everything depend on the proportion between commodities and money.” Chapter 16 – Domestic and international dimensions of monetary policy

2. Transactions demand: Walking around money Precautionary demand: Emergency liquidity Asset demand: Asset markets become too risky, it is better to sit in cash. Still lose money to inflation, but don’t risk losing it all. Interest rates don’t determine saving as much as income does, but interest rates or rates of return do determine how it is saved. Money seeks the highest rate of return at the lowest risk. Demand for money

3. Throughout the chapter, the demand for money curve remains stationary without considering other variables that might alter the desirability of holding either US Securities or cash. If we assume the Keynesian perspective is correct and there is a glut of loanable funds permeating all of the markets (real estate, gold, Wall Street, commodities, etc.) and that asset inflation has made the going price of these assets unrealistic. We further surmise that intelligent investors recognize that these prices make no sense and a bust is imminent, it would follow that safety, rather than return on investment (ROI) may be the clarion call for the demand for money. This would better explain why we see corporations sitting on trillions in cash. It would also indicate that the Fed has lost control of monetary policy. Demand for money curve

4. Keynesian: To adjust the money supply to keep up with economic growth to provide a balance of acceptable rates of unemployment and inflation. Supply-side: Targeting low rates of interest to increase investments and therefore the money supply, thought to be the source of growth. Austrian school: Growth based on borrowing is unsustainable. Boom and bust cycles. Goal of monetary policy

5. SRAS curve is upward sloping but it does not have to be. If the money supply increases proportionally at the same rate as GDP, it is possible to minimize inflation without curtailing growth. An increase in the money supply alone will not accomplish this goal. There must also be an increase in demand and increases in the factors of production. If the economy grows from $14 trillion to $15 trillion in real terms without a change in the money supply, then deflation is occurring. Keynesian paradigm monetary policy

6. Low interest rates makes the aggregate demand curve shift as consumers and businesses are willing and able to purchase more based on future income. Lower interest rates encourage net borrowing and discourages net saving, making economic growth tomorrow impossible unless all of the borrowing today is invested in ways to increase productivity tomorrow. Supply-side monetary policy

7. The text indicates that the Fed, in order to be effective, must sell low and buy high. This is an outcome that would be very profitable for the banks. The actions of the Fed make sense in supply-side doctrine, they do not in the Keynesian paradigm. You should understand the value of bonds based on interest rates. interest payment/principle = interest rate OR interest rate x principle = interest payment OR interest payment/interest rate = principle Fed influences interest rates

8. The example in the textbook of dropping money out of helicopters might be a better way to expand the money supply than is currently being practiced. In order to increase consumption today, the average worker will need to trade on their future income to secure loans from the financial sector, effectively selling future labor. If the money simply fell from the sky, they would not have to reduce consumption tomorrow to pay for increased consumption today. Increase in the money supply

9. Indirect effect of increasing the money supply. This paragraph (pg. 350) is exactly the kind of spending free-for-all that the Austrian School warns against. Note the emphasis on spending increases on homes, cars, and entertainment centers. Borrowing your way to expansion is a guaranteed formula for boom and bust. Effects of increasing money supply

10. Supply-side: Lower interest rates increase demand, higher interest rates decrease demand. Keynesian: demand is dependent on income. If income levels are growing faster than production can expand to keep up with demand, contractionary monetary policy can reduce the money supply and thereby reduce the dollars chasing after goods and services. If interest rates go up, then middle class households will be more inclined to save. Figures 16.3 and 16.4

11. The export of manufactured goods falls into conflict with the export of financial products. A similar issue is faced by oil exporters when the price of oil is increased. Known as “Dutch disease”, net exporters of oil face inflation at home and exports of manufactures drops. During the oil crises of the 1970s, nearly every oil exporter was in social turmoil as a result of these issues. Net export effects

12. Benjamin Cohen: Proposes that policymakers may only pursue two of three policy objectives at one time. The three are the free movement of capital, monetary policy autonomy, and a fixed exchange rate. Capital mobility is difficult to control, so the free movement of capital is often one of the choices though policymakers would often prefer it were not. With a fixed exchange rate, fiscal policy is more effective and monetary policy is less effective With a variable exchange rate, monetary policy is more effective and fiscal policy is less effective During the bulk of the Keynesian paradigm we had greater capital controls and a fixed exchange rate. Triad and the unholy trinity

13. Textbook explanation: Increase in money supply, individuals find themselves with more money than they want and so they make a conscious decision to spend more. If individuals are indeed making this decision, it would follow that we should see a rise in GDP. Alternative explanation: Businesses seek to maximize revenues, if consumers are holding more money, they are able to charge more for their goods and services. Consumers are buying pretty much the same quantities of goods and services, they just have to pay more for them. Example: College tuition and healthcare have been experiencing double digit inflation for years, not because we want to spend more, but because it is possible to charge these higher rates. Businesses do not want to leave money on the table. Explanation of inflation

14. MV = PY M = Money supply V = Velocity of money, or frequency with which a dollar will change hands in transactions throughout a year. (This does have a relationship to the multiplier effect) Nominal GDP/Money supply P = price level or index Y = Real GDP per year, or output The equation of exchange

15. Hume’s quote: “It seems a maxim almost self-evident, that the prices of everything depend on the proportion between commodities and money.” If there is a change in the economy of one of these variables, then one or more of the variables must also change. The textbook offers the example of an increase in the money supply with velocity and GDP held constant. This is an example of an economy “printing money”. The result is inflation. Another example that shows the importance of competency in monetary policy is if GDP increases and velocity and the money supply remain constant we would then experience deflation. Deflation freezes the credit markets and will often create severe unemployment. The quantity theory of money and prices

16. Many assumptions here: Individuals will find themselves holding too much cash and will seek to invest. This may be true of the wealthy, but not necessarily 80% of the population. This is a distribution issue. Those who seek to invest will buy bonds. As seen earlier, buying bonds when interest rates are low is risky. Interest rates could increase and the value of the bond could drop. Keynesian view backed by the data: Excessive dollars held by wealthier individuals and corporations will seek those avenues that will provide the greatest return on investment. Whether it influences GDP is dependent on the nature of the asset pursued. Real estate - GDP is affected, stocks - GDP is not. Growth vs asset inflation is dependent on demand. The three economic crises that correspond to the less progressive tax structures on the chart given to you had declines in interest rates and real estate bubbles associated with them. Interest-rate-based transmission mechanism

17. This figure offers another example of the faith that interest rates and not income determines demand. If this were the case, the record low interest rates of today should be providing rapid economic growth. Figure 16.7

18. “Targeting the interest rate forces the Fed to abandon control over the money supply. Targeting the money supply forces the Fed to allow the interest rate to fluctuate.” These tow are how a monetarist looks at monetary policy. The textbook limits the choices of the Fed to targeting interest rates or the money supply. There are other options: Targeting nominal GDP Targeting inflation rates These last two are methods preferred by the Keynesian paradigm, in large part because the results of the policy are readily discernible and the independent Fed policies become more transparent. Targeting the money supply and interest rates benefit banks at the expense of the broader economy. The government has little say as to what goes on at the Fed, member banks do. The fed’s target choice

19. Who determines policy priorities?

20. Money supply: Early monetarists advocated growing the money supply in a relatively steady manner so that economic growth is not stifled by a lack of sufficient money to conduct all of the desired transactions. Interest rates: If you believe that low interest rates increase demand independent of income and distribution, you would have a goal of low interest rates. Both Keynesians and the Austrian School would argue against this as unsustainable with a cycle of boom and bust as being inevitable. Fed targeting

21. Nominal GDP: The Fed targets a particular growth rate in the economy, say 4%. If nominal GDP indicates more rapid growth, the Fed uses contractionary monetary policy to slow the growth rate. Inflation: Inflation is negatively correlated with unemployment (with time lags). By targeting inflation, and by extension unemployment, the Fed keeps the money supply as close to the amount necessary to achieve the LRAS as possible. Fed targeting

22. Inflation and unemployment are negatively correlated. This observation was made by William Phillips in 1958. Further economic studies served to confirm this relationship. The strength of this relationship appears to also depend on fiscal policy. The more progressive the fiscal policy, the stronger this relationship. The sacrifice ratio is the percentage of unemployment that will need to be tolerated to reduce inflation. IE 2 percentage points inflation = 1 percentage points unemployment Inflation, the Phillips curve, and the sacrifice ratio High inflation operating to the right of LRAS. High unemployment operating to the left of LRAS.

23. Follows with the faith that low interest rates are expansionary and high interest rates are contractionary. The current rates are at record lows, the Fed has nowhere to go. Federal Funds rate: Rate that banks pay in the federal funds market to borrow from other banks. Discount rate: Rate at which banks borrow directly from the Fed. Interest rate on reserves: Previously, the opportunity cost of holding reserves was a cost of doing business, now taxpayers are paying banks to meet this requirement. Targeting interest rates

24. The Federal Funds Rate is lower than the interest on required reserves. Banks can borrow at the federal funds rate then earn a higher rate in their reserve accounts. Banks can also borrow from the Fed and turn around and purchase securities. Borrow from the government at low rates and lend it back at higher rates. Easy money

25. If you believe that low interest rates are expansionary monetary policy, your goal will be to keep the federal funds rate low. The Fed will take action to increase the supply of reserves to lower the rate, or decrease the supply to increase the rate. FOMC Directive: Targeting interest rates. Considering the make up of the Fed, would we expect any policy other than one that proves to be profitable to the banks? Targeting the federal funds rate

26. One hour each weekday. Buy government securities to increase reserves and lower rates, sell government securities to reduce reserves and raise rates. Trading desk

27. This target is built on the belief that interest rates determine demand. The intent, therefore is to keep equilibrium GDP at a point where the AD, the LRAS, and the SRAS all intersect at the same point. This same kind of targeting is used to target either the NAIRU or a specific rate of inflation. The Non-accelerating inflation rate of unemployment is that rate of unemployment that includes frictional and structural unemployment. Estimates of the NAIRU vary from 5.5% to 7.5%. The Fed is currently defining the NAIRU as 6.5%. nEutral federal funds rate

28. Basically, the argument is that if the economy starts to heat up and inflation is a concern then the Fed should take steps to raise the federal funds rate by purchasing more government securities and making less money available to banks. If the economy is slowing down, the Fed should seek to reduce the federal funds rate by buying up more securities. If your federal funds rate is at .25% and the economy is still struggling it would seem that your policies are not working. It all comes down to whether you believe that economic crises are the result of consumers not having enough money to spend, or businesses not being able to access enough money to invest (as opposed to hoard or save). Businesses are now sitting on trillions in cash. Targeting the federal funds rate

29. Supply shocks are those instances where a factor of production previously available to the economy is unavailable in the same quantities. With a supply shock we tend to see the relationship between unemployment and inflation break down. With the war in Viet Nam we saw a reduction in the workforce from two factors: an increase in service members and an increase in college enrollments to avoid the draft. Close on the heels of the war was the two oil crises of the 1970s. In order to move the LRAS to the right to accommodate larger populations, more energy was necessary but unavailable. Inflation and supply shocks

30. Besides the fact that targeting an interest rate is based on the belief that consumption is based on the interest rate, this form of targeting fails to recognize the effects of maldistribution of income in society. If net savers (those with a MPC approaching 0) are awash in cash with no place to go, interest rates will be low as supply is high and demand is low. In the discussion of the Taylor Rule, we see that it would have required negative interest rates, in other words, lenders would have to pay borrowers money to borrow their cash. How low can you go?