macro economics 4

8/9/2019 Macro Economics 4

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David ParsleyBusiness in the World Economy

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Management 321: Module 2a

nReview: last topic (modules 1a 1c)qThe National Income Accounts (NIA) identity can be

manipulated to answermany questionsqIt shows how aggregate (economy wide) concepts

(savings, fiscal policy, the Current Account,Investment, are related)

qThe Balance of Payments (BOP) identity is derived from the

NIA identity. It quantifies the relationship between cross-border savings and investment flows and goods andservices flows

Module 2a:

nMoney & Monetary PolicyqMoney in the economy: can there be too much?qThe Federal Reserve

qMonetary policy & its 3 (classical) toolsqThe Fisher Equation


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2David ParsleyBusiness in the World Economy

Money & Inflation

1st, What is money?

Up to this point in the class, the questions havedealt with real income, output, GDP, tradeflows, Investment, etc.What is money?

1.unit of account (translates real into a commonunit: nominal) (we can add heart surgeries, autos,oranges, etc. using their monetary value when computinga nations GDP)

2.store of value (a good money doesnt lose its valuequickly, thus market participants are penalized by using

money)3.medium of exchange. Money greatly facilitates

tradeq since money can buy goods & services, rather

than searching for mutually beneficialtransactions in goods & services, it

improves the efficiency of the economy


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Money and Inflation

n Money can be: (a) commodity basedcommodity based e.g.,gold, silver, diamonds, cigarettes, etc., or,money can be (b) fiat money -fiat money - as most

currencies in the world are today.q Fiat money is created by a law that defines what a nationsmoney is. Usually countries, through their laws give thepower to create money to the national Central Bank

n Inflation occurs when the change in the

overall price index is > 0q inflation implies the purchasing power ofmoney is declining

q Observation: if we are concerned about the purchasing powerof money, we need to know something about what causesinflation


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Basics: How do we measure the amountof money in the economy?

There are different definitions of money depending onhow inclusive we want to be:n C: Currencyn M1: Sum of currency, demand deposits, travelers

checks, and other checkable depositsn M2: Sum of M1 and overnight repurchaseagreements, Eurodollars, money market depositaccounts, money market mutual fund shares, andsavings and small time deposits

n M3: Sum of M2 and large time deposits and term

repurchase agreementsn L: Sum of M3 and savings bonds, short term

Treasury securities, and other liquid assets

This list is intended to illustrate various ways of defining money and is not meant to be memorized.


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An Important Distinction

n Monetary policy versus fiscal policyq

n What is Fiscal Policy?What is Fiscal Policy?q Fiscal policy: changes in G or TFiscal policy: changes in G or Tq

NIA: Y = C + I + G + NX, G is government spending.q G is decided by Congress and the Executive brachesG is decided by Congress and the Executive braches

q

n What is Monetary Policy?What is Monetary Policy?q Monetary Policy:Monetary Policy: Changes in the Money supply and/orChanges in the Money supply and/or

interestinterest ratesrates

q In the U.S., theIn the U.S., the Federal ReserveFederal Reserve controls the Moneycontrols the Moneysupply and thus has exclusive responsibility forsupply and thus has exclusive responsibility forMonetary PolicyMonetary Policy

q The Federal Open Market Committee (FOMC)The Federal Open Market Committee (FOMC)determines Monetary Policy determines Monetary Policy notnot congress or thecongress or thePresident!President!


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Can there be too much

money in an economy?1


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Sometimes the Central Bank prints too

much money(usually because the government has ordered it to)

n If the government doesnt collect enough taxes to payfor its spending (T


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Key Concept:

The Quantity Theory of Money

MV = PY M = money V = velocity

P = Price level Y = real output

n

n The Quantity theory predicts thatexcessive money growth willultimately (i.e., in the Long Run)result in inflation


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Inflation (%P) is a monetary phenomenon

n MV = PY quantity theory %M + %V = %P + %Yn

n The theory says growth in 4 things (m, v, p, y) are relatedq In the long run the growth of real GDP (%Y) is

determined by the growth of inputs (labor force, capital,and technological change),

q and velocity (V) can be considered a technologicalconstant, according to the Quantity Theory. V is thenumber of times a dollar turns over in a year to finance

all the transactions comprising GDP.q

n ThusThus, the Quantity Theory implies that inflation (%P)is determined by money growth (%M) in the longrun

See FAQ Handy approximations


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Does the quantity theory work?U.S. Money growth and inflation

Source: Mankiw, p.88


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Worldwide Money growth and inflationin the 1990s

Source: Mankiw


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Germany during its Hyperinflation

How much inflation is that?an policymaking today! Prior to the introduction of the euro (& hence the European Central Bank) the German Cen


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Monetary Policy:Actions taken by the Federal Reserve

The 3 tools of monetary policyn Discount rate: It is the rate at which banks borrow

from the Federal Reserve. A higher discount ratecontracts money supply in the economy.

n Reserve requirements: All banks are required tomaintain a percentage of reserves in relation to thedeposits. Higher reserve requirements lead tocontractionary monetary policy.

n Open market operations: Buying and sellinggovernment bonds (no new issues) on the open

market. Open market operations impact thefederal funds rate.q Update: various auction facilities: pre-announced

fixed amount auction term funds directly to depositoryinstitutions & discount window has been opened tonon-depository institutions.


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Open market operationsOpen market operationsThe most important tool of monetary policy!

n When the Federal Reserve buys or sells existinggovernment bonds, the money supply in the hands ofthe public changes

n When the Fed sells government bonds (for example), ittakes the money it receives out of the system. This

reduction in the supply of money drives interest ratesup. This is an example ofcontractionary monetarypolicy

n The Fed Funds rate is the interest rate that tends toreact first. It is the rate at which the banks borrow from

each other on an overnight basisq Banks borrow (overnight) in the fed funds market in

order to maintain their required reserves, and theylend when they have excess reserves

n ExpansionaryMonetary policy is the reverse: i.e., theFed buys government bonds


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Q1: How is the Fed Funds rate affected by openmarket operations?

Q2: How does the Fedpayfor the bonds?

Source: http://www.ny.frb.org/research/capital_markets/capitalmarkets_indicators.html


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Brief history of the Fed

n Recurring financial panics led to theFederal Reserve Act in Dec. 1913

n Mandate to preserve financial and

economic stability through supervisionof banks and conduct of monetarypolicy

n 12 regional banksn Independence

More detail at:http://www.federalreserveeducation.org/fed101/History/index.cfm
http://www.federalreserveeducation.org/fed101/History/index.cfmhttp://www.federalreserveeducation.org/fed101/History/index.cfm


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Federal Reserve Districts


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The leadership of the Federal

Reserve System

n

n Board of governors (7 members), one appointed byPresident to be Chairman for 4 years

n Current Chair is Ben Bernanke (appointed 2006)

n The FOMC: 7 governors, the president of the NYFed, plus 4 of the presidents of other regional Fedbanks

n The trading desk of the NY Fed makes all changes tothe Feds portfolio through purchases/sales of

securities that are already outstanding. Typically,a desk purchase on a particular day may runaround 10% of that days market volume


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Next topic:Interest rates: real vs. nominalThe Fisher Equation

n The Fisher equation is very simple butits implications are profound

n The Fisher equation states that the

nominal interestrate (i) is comprisedof a real interestrate (r) plus apremium (e) for expected inflation

Fisher equation: i = r + e


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The intuition

n Suppose you were lending moneyq (which is what you do when you put your

money in the bank, or a money market fundfor example).

n You will demand a real returnq That is, the money you lend should retain its

purchasing power as well as earning a realreturn

q Alternatively, think of the borrower. A borrower

needs money for a project with a real return.Thus, borrowers will be willing to pay for theuse of the funds money

n the nominal interest rate is the opportunitycost (return foregone) of holding money


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Applying the Fisher equation:

Does the nominal interest rate reflect inflation?


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Applying the Fisher equation:

An implication of the Fisher equation

n Heard on the street: last year I earned6% on my savings. But we had 3%inflation. I really hate inflation

because it ate into my 6% return leaving me with only 3%.qEvaluate this statement


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The Fisher Equation around the world


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Take Aways (part 1)

n The Federal Reserve controls theMoney supply Monetary Policy

n Three tools of monetary policy

n Open market operations are the mostimportant

n The Fisher equation relates nominal

and real interest rates and expectedinflation


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Short Run Versus the Long Run

Definitions:n The distinction between the short run and the

long run - is the flexibility of pricesn

In the long run all prices are flexibleq Hence, real resources (output, capital, labor)can adjust accordingly - no unemployment!

q Keynes famously quipped in the long runwere all dead. Basically he was saying that

the short run is more relevant in manyinstances

n The short run is that transition period beforeprices have fully adjusted


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SR vs. LR: Implications & why it matters

n In the SR, resources may not be at their LR optimumq Output may be below potential,q unemployment may exist, andq government policies (e.g., monetary policy) have real

effectsq That is, in the long run, when by definition prices have

adjusted, we are at full employment of resources.Hence government policies cannot have real-effects

n Bottom line: the world works differently in the SR & inthe LR

n How does the short run correspond to time?q In some markets the short run is an instantq In some markets the short run is yearsq it depends

q


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Why dont prices adjust?(i.e., why arent we always in the LR?)

n It may physically cost something to changeprice (menu costs), or,q It may cost business relationships to adjust

pricesq

Contractsn At some level, it doesnt matter why

q The fact that prices dont adjust implies thatquantities adjust

q Market systems rely on prices to clear markets

q Whenever prices dont adjust shortages and orqueues develop. That is, in a system withprice flexibility, there CANNOT be ashortage, or a surplus, or evenunemployment (which is just an excess supply oflabor)!


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Monetary Policy Review(Key slide)

n A decrease in the money supply is achieved by theFed selling bonds

n

n This raises interest rates (Fed Funds rate), i.e., to sellbonds the Fed must offer a low price (= raising theinterest rate)q Since it is the short run, both real and nominal

interest rates risen

n The interest rate rise impacts the overall economy.How?

n Short runq money r Investment Y ( RGDP)

n Long runq P

(Hint: you must know the above)


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tradeoff between

unemployment and inflation

n The key is the short run impact of monetarypolicy on unemployment

n The short run reduction of the money supplyresults in a rise in unemploymentq monetary policy determines the amount of

unemploymentq Not: imports, exports, fiscal policy, current

account, taxes, etc.

n Thus, all the discussions in the press aboutthese things is simply beside the point froma macroeconomic perspective!


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The Role of the Central Bank

n A nations Central Bank, through its use of monetarypolicy influences the real economy in the short run,and inflation in the long runq A central bank also attempts to monitor and promote

financial stability

n In some countries, the Central bank is essentially anagent of the government (not independent) financing government deficits by printing money

n This is a recipe for economic mismanagement &frequently results in hyperinflation. One solution tothe problem of non-independence or badcentral bank policy, is to remove the CentralBanks ability to print money by adopting aCurrency Board, or dollarize, or createinstitutions that will result in good monetarypolicy


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Take Aways (part 2)

n Thedistinction between the short runand the long run - is the flexibility ofprices

n In the long run all prices are flexibleqHence, real resources (output, capital,

labor) can adjust accordingly

n

The short run is that transition periodbefore prices have fully adjusted


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32David Parsley

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http://www.portfolio.com/slideshows/2008/3/Worlds-Most-Worthless-Moneyhttp://www.portfolio.com/slideshows/2008/3/Worlds-Most-Worthless-Money

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