ECN202: Macroeconomics 1970s: Experiments with Money The Domestic Dimension "neither a state nor a bank ever has had unrestricted power of issuing paper.

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."

1970s Domestic1970s 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.

In the newsIn the news

1. “Interest rates on Italian bods pushed to new levels”

2. “Italy Rates Remain Near Two-Year Record Low”

3. “The world isn’t flat, but its yield curve may be”

4. “States and cities start rebelling on bond ratings”

5. “International capital flows alter US interest rates”

6. “Poland Finds It’s Not Immune to Euro Crisis”

7. “China Cuts Lending Rate as Economic Growth Slows”

8. “As Low Rates Depress Savers, Governments Reap Benefits”

9. “Low rates may do little to entice nervous consumers”

In the newsIn the news

1. “Fed's Move Toward 'Monetarists” 1972

2. “Humility at the Fed; Inflation Brakes Don't Work So Well” 1973

3. “Fed May Be Sharply Expanding Credit Supply, Analysts Assert” 1973

4. “Fed Tries Way Of Monetarists” 1979

5. “Economists Criticize Volcker; Galbraith Issues Warning” 1979

6. “Miller Suggests Fed Moved Too Quickly; Uncertainty on Third Step” 1979

7. “CAN VOLCKER STAND UP TO INFLATION?” 1979

In the newsIn the news

1. “Pain spreads as credit vice grows tighter”

2. “The Fed’s monetary policy response to the current crisis”

3. “How the Fed can fix the world”

4. “Paying the price for the Fed’s success”

5. “The Fed plans to inject another $1 trillion to aid the economy”

6. “Fed Chief’s reassurance fails to halt stock market plunge”

7. “Fed ties new aid to jobs recovery”

8. “Dear Ben: It’s time for your Volcker moment”

9. “Rising inflation limits Fed as growth lags”

A great invention?

1. "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."

2. "[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."

A few things to know about interest rates

1.) there are many interest rates that tend to move together.

A few important interest ratesDiscount 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

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

Look at these graphs on next few slides and see if you can see the similarities – and differences

Rate on banks overnight borrowing targeted by Fed

Rate on US government debt with 6-month maturity

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?

Rate on US government debt with 10-year maturity

Rate on 30-year mortgages – this impact housing demand

You can see that the 1970s was a problem

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%.

monthly payment would be on a $100,000, 30-year mortgage,

18% = $1,5485% =.$536

What will this reduction in rates do to demand for homes?

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.

Decomposition of interest rates

r = rr + rd + rm+ ri + rl

wherer = 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

Default Risk

Corporate Aaa

Municipal

US 10-yr Treasury

Corporate debt is riskier = higher interest rate

Municipal rate – lower because of tax benefits

International examples of default risk

1. Argentina Crisis of 1997-1998

2. Asian Crisis (Hong Kong) of 1997

3. Subprime Crisis of 2008

4. Greece Crisis of 2009-2010

1. Argentina Crisis of 1997-98

Argentina Interest Rates

2. Hong Kong Crisis of 1997

3. Subprime Crisis of 2008

The default premium on corporate bonds increases in recession as investors worry about corporation’s ability to pay bills

3. Subprime Crisis of 2008

Another view of same phenomenon – the gap between the two rates increases in uncertain/bad times

4. Greece Crisis of 2009-2010

Investors get very worried about Greece

Maturity Risk

10-yr

3-mth

3-month is less risky than 10-year

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?

Inflation Risk

3-yr TreasuryInflation

You can see that interest rates are closely correlated with inflation rates.

What happened in the late 1970s – and early 1980s?

Real and Nominal Rates

rn = rr + ie

or

rr = rn - ie

whererr = real rate

rn = nominal rate

ie = expected inflation rate

You saw this before – the relationship between real and nominal interest rates

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.

A few things to know about interest rates (the price of money)

3.) interest rates are prices

a. Keynesian theory of money demand

b. 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

Interest rates are prices

r* = interest rates

ms* = money supply (M1)

Md

Ms

Ms

Md

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

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**

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

m*

**

m**

Md

Money supplyInterest rate

Money

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

1.Federal Reserve – control the S of cash (high-powered-money)

2. Commercial Banks – control the amount of checking accounts issued

3. Businesses & Households – they are the users of the money and decide what form of money they want to hold.

Money Supply Process

FedFed

BanksReserves

BanksReserves

Individuals & Businesses (Ms)Checking Account $s + Cash $s

Individuals & Businesses (Ms)Checking Account $s + Cash $s

$s$s

$s$s

$s$s

Money supplyPlayers 1. Federal Reserve (FED)

– This institution controls the supply of high-powered money (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.

Federal Reserve structure

Money supplyPlayers 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.

What happens in a fractional reserve systemThink 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.

Banks & fractional reserve system

Regulations of commercial banksBecause 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.1.Deposit insurance: deposits were guaranteed by the federal government, which eliminated bank runs2.Bank examinations: the books of banks were regularly reviewed3.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)4.Required reserves: banks must hold a percent of their outstanding deposits as cash – the required reserve rate

Money supplyPlayers

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

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.

What affects the Money Supply?

The factors affecting the money supply fall into two categories depending on the Fed’s control.

1.Uncontrolled influences

2.Controlled influences

Now we will look at what would be included in these two

Uncontrolled influences on Money Supply

1. 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.

2. 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.

Controlled influences on Money Supply

1. 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.

2. Required reserve rate: If the Fed lowers the required reserve rate then the bank can lend out more which means an increase in Ms.

3. Discount rate: If the Fed raises the discount rate then it is discouraging banks from lending money, which reduces the Ms.

Fed policies to increase Money Supply

1. OMO: it would buy Treasuries and pay for them with new $s that would expand the Ms.

2. Required reserve rate: the Fed would lower the rrr so banks could lend out more for any amount of reserves.

3. Discount rate: fed could lower the discount rate that encourages banks to borrow $s from the Fed to lend out and increase Ms.

If the Fed would like to increase the money supply then it would

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

Money MarketMoney Market

QuestionsQuestions

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)

Get that piece of paper out and draw the appropriate diagrams

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

Interest rate

money

QuestionsQuestions

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

QuestionsQuestions

c. How do you show the impact on the money market of the Fed’s Open Market purchase of securities?

Interest rate

Money

QuestionsQuestions

d. How do you show the impact on the money market of people decision to convert their checking accounts into cash?

QuestionsQuestions

e. How do you show the impact on the money market if the economy falls into recession and the Fed buys securities (OMO purchases)?

QuestionsQuestions

QuestionsQuestions

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 - this increases demand for money = right shift in Md = interest rate & Ms

b. The Fed’s decision to raise the discount rate – this decreases supply of money = left shift in Ms =

interest rate & Ms

c. The Fed’s Open Market purchase of securities – this increases supply of money = right shift in Ms =

interest rate & Ms

QuestionsQuestions

What would be the impact on interest rates of the following, and how would you show it with the Ms-Md diagram?

d. People decision to convert their checking accounts into cash – this decreases supply of money = left shift in Ms = interest rate & Ms

e. The economy falls into recession and the Fed buys securities (OMO purchases) – this is a double shift - decreases demand for money (recession) = left shift in Md & increases supply of money (Fed) = right shift in Ms. Combined effect is interest rate & can’t predict Ms

8f. What is Fed doing in 1991 – and why?

(rr)

QuestionsQuestions

Get that piece of paper out and draw the S&D graphs of the money market

The fed was driving down interest rates, which it did by increasing the money supply. It probably bought Treasuries using OMO to increase the Ms.

QuestionsQuestions

Monetary Policy

What can monetary authorities do to manage the economy?

QuestionQuestion

Here are two time-series graphs – one of the discount rate in the US and one of the equivalent (bank discount rate) in Japan. Please look at the graphs and do a little reverse engineering to determine what was going on in the two economies during this 20+ year period – and what the monetary authorities in the two countries were doing to “manage” the economy?

What is happening here?

Why the difference in the 1990s and why the drop after 2001?

The short answer is you can see Japan’s “lost decade” in the graphs. Japan’s central bank had raised the interest rate in the early 1990s to stop a speculative boom, and once the bubble burst it lowered interest rates dramatically and had to keep them near zero trying to stimulate the economy. In the US the economy fell into a recession in the early 1990s so the Fed also lowered rates, but then began to raise them as the economy heated up in the Clinton years. In the US after 9/11 and the stock market bust the Fed flooded the economy with cash and kept them low. This fueled the housing boom in the US that eventually led to the financial crisis and the Great Recession.

Now that we see how the money market works, you should see what comes next. In the 1970s Nixon “set the Fed free” so the US could print money, and when the two recessions induced by OPEC price increases happened, the Fed responded as Keynes would have suggested. We will now look at the Keynesian theory of monetary policy and its influence on the economy. We’ll also look at The Wizard of Oz in a way that you never did – as an allegory about monetary policy. First, however, we recap the Classical “Quantity Theory of Money.”

Monetary Policy and the EconomyMonetary Policy and the Economy

Classical “vision” of monetary policy:

Quantity theory of money

M P

You have to love the simplicity – if you print more money people will try to spend it and because we are at full employment this will result in asn increase in prices.

Keynesian “vision” of monetary & fiscal policy

Monetary Policy

M rr I Y

Keynes’ view was a little more involved. An increase in the money supply (M) would push the interest rate (rr) down and this would stimulate investment(I) spending and this increase in Investment spending would have a multiplier effect on GDP (Y).

Now let’s look at what this does to fiscal policy

Keynesian “vision” of monetary & fiscal policy

Fiscal Policy

GY MdrrIY

(crowding out effect)

Keynes’ view of fiscal policy changes a bit. Now as the economy expands (Y) as a result of the increase in government spending (G) there is a secondary effect. The increase in income increases money demand that increases the interest rate ( r ) and this reduces Investment spending (I) that reduces overall national output (Y). This secondary effect is crowding out and it reduces the full multiplier efect.

Keynesian Monetary Policy Transmission Mechanism

0 Recognition and Discussion lags

1 Sensitivity on Md to interest rate

2 Sensitivity of spending to interest rates

3 Spending’s impact on price & output

Now let’s look at that transmission process

What happens if it is discovered that consumption of automobiles is more sensitive to changes in the interest rate than previously thought, what impact will this have on the relative effectiveness of monetary and fiscal policy?

QuestionQuestion

Try to work your way through the logical chain of events in the diagram in the following slide. Find the link between interest rate and Investment in the diagram and then see how a change in money supply (M) can have an impact on GDP (Y)

Answer

Monetary: Keynesian version

M rr I AD Y

Fiscal: Keynesian

G AD Y1 Md

r I AD Y2 Here are the two places the link between the interest aret and investment show up. Now what happens to the links?

Answer

Monetary: Keynesian version

M rr I AD Y

Fiscal: Keynesian

G AD Y1 Md

r I AD Y2

Bigger = more effective

Bigger = less effective

The first effect dominates so it is more effective

In the next side you see the Fed’s dilemma – by altering the supply of high-powered money it can control either the price (interest rate) or quantity (Ms). It has to decide what to control, and that is where the ideological divide happens.•Keynesian/ liberals – believe the interest rate is the key variable to control•Classical/ conservatives – believe it is important to control the money supply

The Fed’s dilemmaThe Fed’s dilemma

So, when the economy is “hit” by the OPEC oil price shock and falls into a recession, what will the liberals propose – and what would the conservatives propose?

Fed’s dilemma: respond toMd

Control interest rate Control money supply

Increase Ms Decrease Ms

Lose control of M Lose control of r

Ms

Md

Ms

Md

Now let’s look at what happened in the 1970s. OPEC raised prices and this increased Md and this put pressure on interest rates to rise. This would have pushed investment and consumption spending lower and caused a recession. To avoid this the Fed increased the money supply and this pushed won interest rates but also increased inflation which pushed interest rates up. The fed pumper more money in and for the decade this pattern continued as you can see in the following diagram

The 1970sThe 1970s

Story of the 1970s

Interestrate

Q Money

P Md

Fed responds to r by Ms

Fed responds again Ms P Md Ms P Md r

The end result of the process was the US experienced persistent and increasing inflation – the only time in peacetime in the country’s history. What happened was that Carter eventually responded with the appointment of the conservative Paul Volker as Fed Chair who changed strategies abruptly. He adopted Monetarism, an idea pushed by conservatives who believed in the need to shift focus to the money supply. Inflation was the result of too much money, so now it was time to control the money supply. We can see what happened in the following diagram.

The “Shift”The “Shift”

The Fed under Volcker reduced the money supply

This increased the interest rate, which would be hard o claim as a target

The Fed ignored interest rates and announced M targets that seemed better politically

A shift to MonetarismA shift to Monetarism

Md

Ms

The Fed’s policies sent the US into its deepest post WW II recession and soon after the recession the monetarism policy was abandoned. It created much human misery, but it did break the inflationary spiral and set the stage for the second part of the ideological revolution – the arrival of Ronald Reagan with his supply-side policies.

The resultsThe results

And now let’s revisit those early questions

Those questionsThose questions

As we go through the analysis keep the following two question in mind.

1. Please explain. "the memory of the Great Depression meant that the US was highly likely to suffer an inflationary episode like the 1970s in the post-World war II period-maybe not as long, and maybe not exactly when it occurred, but nevertheless a similar episode.”The reasoning behind the quote is that Keynes had provided the basis for using monetary policy to stimulate the economy, and eventually the Fed would use it. Because Keynes was writing in the 1930s when inflation was not a problem, Keynesians ignored it and the result was Fed policies that would produce the policies of the 1970s that created persistent and increasing inflation

Those questionsThose questions

As we go through the analysis keep the following two question in mind.

2. "Long after the Pope is gone, you'll remember this?"  What is the change in policy that is being referred to here, who was responsible for the change, and why was the policy change quickly called off?

This was a simple one – it was the shift to monetarism that created those double-digit interest rates (my 18.% mortgage) and this was truly a shock to the system that would have a bigger impact that the Pope’s visit.

And one final question on the story the Wizard of Oz.

The Wizard of Oz as Political Allegory

What is the “economic” story behind The Wizard of Oz – and who do the characters represent? Who is William Jennings Bryan in the story – and in real life - and what was his Cross of Gold speech and how was it related to the story?