Introduction and Course OverviewECON 40364: Monetary Theory & Policy

Eric Sims

University of Notre Dame

Fall 2017

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Readings

I Mishkin Ch. 13, pg. 292-309

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Monetary Theory and Policy

I Investopedia defines monetary theory as “a set of ideas abouthow monetary policy should be conducted within aneconomy.”

I Wikipedia defines monetary policy as “the process by whichthe monetary authority of a country, like the central bank orcurrency board, controls the supply of money, often targetingan inflation rate or interest rate to ensure price stability andgeneral trust in the currency ... Further goals of a monetarypolicy are usually to contribute to economic growth andstability, to lower unemployment, and to maintain predictableexchange rates with other currencies.”

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Questions

I In this course we’ll be focusing on a series of interrelatedquestions:

1. What is money? What determines the supply of money? Thedemand for money? The price of money?

2. What determines interest rates? Why are they important?Why are there so many?

3. What are banks and bank-like institutions, why are theyimportant, and why are they regulated (either implicitly orexplicitly by central banks)?

4. How should central banks conduct monetary policy in normaltimes?

5. What are financial crises? How should central banks react tofinancial crises? How can central bank policy be structured toeliminate or limit financial crises?

6. What happened during the recent financial crisis and GreatRecession, and what role did central banks play?

I We will (almost exclusively) focus on the US economy and theFederal Reserve

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Lecture Slides

I Lecture slides will be made available on the course websitethrough Sakai

I Important terms or items will be highlighted in blue, whilelinks to outside readings or websites will be in orange

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Syllabus and Course Logistics

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About Me

I Associate Professor, Dept. of Economics, UniversitatisDominae Nostrae a Lacu

I BA, Trinity University, 2003I Miracle in Mississippi

I PhD, University of Michigan, 2009I Don’t get the wrong pictureI Wife proud Lewis Hall ChickenI Signed Charlie Weis picture in officeI Print from 2012 ND-Stanford game in office – straight from

Brian Van Gorder’s basement

I I am Roman Catholic

I And I believe in Bigfoot

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Weis

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Straight Outta BVG’s Basement

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Bigfoot

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Family

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Federal Reserve

I The Federal Reserve (or just the Fed) is the central bank ofthe US

I It was only created in 1913

I Many other countries have had central banks for far longer(e.g. the Sveriges Riksbank [Sweden] was founded in 1668and the Bank of England was founded in 1694)

I By congressional mandate the Fed has three main objectives(the first two of which are called the “dual mandate”):

1. Maximum employment2. Stabilizing prices3. Moderating long term interest rates

I Fed also plays an increasingly large role inregulating/supervising banks and related financial institutionsand in promoting financial stability

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Structure of the Fed

I There are three main entities which comprise the Fed:

1. Regional Reserve Banks2. The Board of Governors3. Federal Open Market Committee (FOMC)

I Twelve member banks are quasi-private owned by commercialbanks within each district. They perform operational dutiesrelated to banking within their districts, and presidents serveon a rotating basis on the FOMC

I The Board controls a majority share on the FOMC and doesthings like set reserve requirements

I The FOMC makes decisions concerning monetary policy,including the target for the Federal Funds Rate (the key policyinterest rate)

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Independence

I The Fed is structured to be more or less independent from theusual political process

I Fed officials are not elected, though they are appointedthrough the political process

I Lots of research stressing importance of independence: a lackof independence can induce an inflationary bias and encouragefiscal mischief

I The Fed, especially since the Great Recession, is increasinglypowerful, so much so that David Wessel refers to the Fed asthe “fourth branch of government”

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Origins of the Fed

I The primary motivation in the founding of the Fed was to dealwith banking panics and subsequent financial crises.

I A particularly virulent banking panic, the Panic of 1907, wasthe impetus for the founding of the Fed

I The main goal was for the Fed to serve as the lender of lastresort, which would hopefully stop banking panics before theystarted

I Other intended goals of the Fed included maintaining themoney supply, to regulate banks, and to provide financialservices to depository institutions

I The goal of the Fed “fine-tuning” business cycle fluctuationsonly evolved over time, with these goals officially enshrinedwith the Federal Reserve Reform Act of 1977 and theHumphrey-Hawkins Act of 1978

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Brief History of the Fed

I It is generally accepted that the Fed failed in its lender of lastresort role during the Great Depression

I For the next 70 years, the US economy didn’t reallyexperience financial/banking crises

I In this time, the Fed’s objective evolved into the use ofmonetary policy to “fine-tune” the economy

I With recent financial crisis and ensuing Great Recession, theFed’s role as lender of last resort came to the forefront onceagain

I The Fed also has an increasingly important role in regulatingand overseeing the financial system

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Structure of the Course

I The course as I have designed it is not quite as linear as Iwould like, in part because the development of central bankinghas not been all that linear

I We will talk about crises and the lender of last resort functionof the Fed last, rather than first

I The course will be divided into three parts:

1. Traditional monetary theory and conventional monetary policy:money supply, money demand, monetary policy as amacroeconomic stabilization tool

2. Topics in finance and banking: bond pricing, term structure ofinterest rates, stock market, information asymmetry andfinancial structure, and banking

3. Financial crises and unconventional monetary policy: GreatDepression, Great Recession, unconventional monetary policy,lender of last resort, questions to ponder

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